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LLM Theses and Essays
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12-1-2001
Corporate Distributions to Shareholders in
Delaware and in Israel
Anat Urman
University of Georgia School of Law
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Urman, Anat, "Corporate Distributions to Shareholders in Delaware and in Israel" (2001). LLM Theses and Essays. Paper 52.
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ANAT URMAN
Corporate Distributions To Shareholders In Delaware And In Israel: Cash Dividends And
Share Repurchases.
(Under the Direction of Professor CHARLES R.T. O’KELLEY)
This thesis considers the corporate legal systems of Israel and Delaware as they
address the subject of corporate distributions to shareholders. The thesis reviews the
significance of cash dividends and the acquisition by corporations of their own stock, in
the management and survival of corporations, the effect they have on the disposition of
creditors, and the extent to which they are restricted by operation of law.
The thesis demonstrates how dividends and share repurchases may translate into a
transfer of value from creditors to shareholders. It considers the effectiveness of the legal
capital in securing creditors’ interest, and concludes that the legal capital scheme presents
no real obstacle to distributions.
It is further concluded that despite the recent corporate law reform in Israel,
Delaware’s corporate law system continues to surpass Israel in flexibility and broad
approach to distributions. Nevertheless it is expected that Israeli courts will consider
Delaware’s methodology on the matter.
INDEX WORDS:
Debt, Distribution, Dividend, Equity, Equity cushion, Fiduciary,
Greenmail, Insolvency, Legal capital, Leverage, Nimble dividend,
Par value, Recapitalization, Redemption, Restrictive covenant,
Repurchase, Surplus, Takeover.
i
CORPORATE DISTRIBUTIONS TO SHAREHOLDERS IN DELAWARE AND
IN ISRAEL: CASH DIVIDENDS AND SHARE REPURCHASES
by
ANAT URMAN
LL.B. The University of Manchester, Israel, 1998
A Thesis Submitted to the Graduate Faculty of The University of Georgia in Partial
Fulfillment of the Requirements for the Degree
MASTER OF LAWS
ATHENS, GEORGIA
2001
ii
© 2001
Anat Urman
All Rights Reserved
iii
CORPORATE DISTRIBUTIONS TO SHAREHOLDERS IN DELAWARE AND
IN ISRAEL: CASH DIVIDENDS AND SHARE REPURCHASES
by
ANAT URMAN
Approved:
Electronic Version Approved:
Gordhan L. Patel
Dean of the Graduate School
The University of Georgia
December 2001
Major Professor:
Charles R.T. O’Kelley
Committee:
Fredrick W. Huszagh
Charles R.T. O’Kelley
iv
DEDICATION
To my parents Malka and Menachem Urman, and to Ron Kalfus.
Thank you for your support.
iv
vi
TABLE OF CONTENTS
Page
CHAPTER
1
INTRODUCTION…………………………………………………………..1
I.
Thesis Background…………………………………………………..1
II.
The Significance Of Distributions To Corporate
Constituencies……………………………………………………….4
2
III.
Israel’s Corporate Law System……………………………………...6
IV.
Thesis Structure……………………………………………………...7
THE CONFLICT OF INTEREST BETWEEN THE
SHAREHOLDERS AND THE CREDITORS……………………………...9
I.
Introduction……………………………………………….…………9
II.
The Conflict Between Debt and Equity……………………….…...10
III.
Eliminating Investment Risks And The Function Of The
Equity Cushion……………………………………………………..15
3
4
LEGAL CAPITAL RULES AND THE EQUITY CUSHION……………18
I.
Introduction To The Legal Capital System……………….………..18
II.
Distributions And Their Effect On Creditors………………………26
III.
Legal Limitations On Distributions………………….……….……29
CRITICISM OVER TRADITIONAL LEGAL CAPITAL
DOCTRINES……………………………………………………….……...45
v
vi
5
MOTIVES FOR ENGAGING IN CASH DISTRIBUTIONS
AND SHARE REPURCHASES……………………………………….….48
I.
Introduction……………………………………………….…….….48
II.
Leveraged Recapitalizations………………………………….……52
III.
The Excess Cash Theory………………………………….………..56
IV.
The Signaling Explanation…………………………………………56
V.
The Bird-In-The-Hand Theory……………………………………..62
VI.
The Takeover Defense Theory……………………………………..63
VII.
Greenmail…………………………………………………………..65
VIII.
Stock Manipulations And The Creditor Expropriation
Theory…………………………………………………….………..67
IX.
6
Stock Redemptions……………………………………….………...69
RESTRICTIONS ON DIVIDEND DISTRIBUTIONS AND
SHARE REPURCHASES…………………………………………….…...74
I.
Restrictive Covenants…………………………………….………...74
II.
Statutory Limitations………………………………………….……76
III.
Limitations Imposed By Case Law..……………………………….80
7
LIABILITY FOR IMPROPER DISTRIBUTIONS……………………...113
8
CONCLUSION…………………………………………………………..118
BIBLIOGRAPHY………………………………………………………..125
CHAPTER 1
INTRODUCTION
I.
Thesis Background
Israel is small country with very few natural resources, facing difficult political
scenarios. Despite these adverse conditions, Israel has reportedly sprouted into the
world’s second most important high-tech cluster after Silicon Valley.1 In a country of
only six million people, there are nearly as many Israeli companies listed on the
NASDAQ (National Association of Securities Dealers Automated Quotation System) as
there are European companies.
The government of Israel has taken an active role in promoting the county’s
technological capabilities.2 The high-tech sector has become a central element in Israel’s
economy, so much so, that its continued success is central to Israel’s economy.
However, it has become increasingly difficult to attract foreign investors to
participate in ventures within Israel. If fact, Israel’s high-tech industry is reportedly
losing its business to foreign countries.3 In the past several years, over ninety percent of
1
Roger Abravanel, The Promised Economy, THE MCKINSEY QUARTERLY, 2001 Number 4
(hereinafter The McKinsey Quarterly). Also available at,
http://www.mckinseyquarterly.com/article_abstract.asp?tk=:1108:7&ar=1108&L2=7&L3=10.
According to The McKinsey Quarterly, during the year 2000, Israeli high-tech start-ups attracted
more investment per head than any other country in the world. Israeli high-tech start-ups attracted $3.2
billion in capital investment, most of which foreign. This amounts to a 30-fold increase in investments in a
period of only three years.
2
Subsidizing and setting up labs, incubators and seed-money venture capital funds.
3
Many companies transfer their business centers and management teams out of Israel. Even when
the research is performed in Israel, the development products are transferred to related companies overseas.
1
2
the new start-up companies that were formed in Israel, incorporated as foreign
companies,4 many of those in the U.S., a majority of which in Delaware.
Why is it then that Israel, an incubator for world-class technological innovation,
is struggling to prevent companies from immigrating to Delaware?
One known turnoff for choosing Israel as a jurisdiction, is its unique system of
corporate law. A major source of funding flowing into the venture capital industry in
Israel originates from U.S. investors who do not believe in the Israeli system. Much
pressure is, therefore, placed on Israeli entrepreneurs to set up their companies in the
U.S. rather than Israel. Clearly, investors are likely to choose a jurisdiction whose laws
are simple and most advantageous. Indeed, we see that among worldwide systems,
those that dominate are systems that have the easiest, clearest, simplest, and most
worthwhile laws governing economics, securities, income tax, and companies. Such
systems compete in the global market because they are compatible with worldwide
leading codes.
The new 1999 Israeli Companies Law, on which work commenced fifteen years
ago, was intended to serve this purpose precisely. However, by introducing an
innovative and revolutionary code, legislators have, in effect, set back Israel’s
competitive position. The new Companies Law is widely criticized as being less clear,
less simple, less predictable, and less user-friendly than its foreign counterparts.
Delaware, which has become a corporate haven for many Israeli corporations,
has been offering an attractive legal landscape for incorporation for over two decades.
4
Ron Tira, Bye-Bye-Tech, GLOBES ISRAEL’S BUSINESS ARENA, June 7, 2000.
3
In fact, a large number of U.S. and international corporations, headquartered
elsewhere, are incorporated in Delaware.5
Delaware is known to have one of the most flexible and convenient series of
company regulations in the world. Over the years, Delaware has led the development
of sophisticated company regulations and a reform of bureaucratic mechanisms that
have made it one of the most convenient places to incorporate.
First, it offers a finely developed corporate statue that presents companies with
a convenient legal environment and an extensive statutory protection for corporate
officers and shareholders. Delaware’s legislators and the Bar Association’s Section on
Corporate Law, constantly revise and update the corporate statutes so that they remain
dynamic and flexible to surging needs.
Second, Delaware maintains a separate pro-business corporate law court
system. On the bench of the Delaware Court of Chancery, sit judges appointed for
their extensive knowledge of corporate law. Over two hundred years of legal
precedent lend Delaware law with predictability and clarity that are fundamental to its
popularity.
Israeli legislators have long recognized the advantages Delaware offers to
Israeli companies. An unprecedented effort is thus being made to produce a
competitive model for Israel.
5
The State of Delaware has been the state of choice for incorporation for more than 308,000
companies, a state of only 1.5 million residents. Sixty percent of the Fortune 500 companies and fifty
percent of the companies listed on the New York Stock Exchange are also incorporated in Delaware. See
Delaware Division of Corporations (visited Sep. 9, 2001), also available at http://www.state.de.us/corp/.
4
II.
The Significance Of Distributions To Corporate Constituencies
“[T]here is no easier way for a company to escape the
burden of a debt than to pay out all of its assets in the form
of a dividend, and leave the creditors holding an empty
shell.” (emphasis added) Fischer Black, 1976.6
Because of the legal structure of corporations, whereby shareholders’ liability is
limited to their respective investment,7 it is suggested that once the corporation becomes
leveraged or financially distressed, shareholders8 have an interest in intensifying
distributions from the corporation’s treasury to external outfits.9 Because the shareholders
are normally not accountable beyond their respective investment for the debts that the
corporation runs up, a diminution of corporate assets, subsequent to the purchase of debt
will, thus, translate into a direct transfer of value from the creditors to the shareholders.
Creditors remain fixed claimants, regardless of the prosperity that the corporation
experiences. Although debt has an absolute repayment priority over equity,10 there are,
nevertheless, numerous ways in which corporate assets may be dispersed, long before
creditors can take legal action to protect their interests.
Two common ways to distribute cash to shareholders are through the
reacquisition of stocks and the issuance dividends. Creditors would ideally covenant to
restrict the corporation from carrying out sporadic distributions, to assure, to the extent
6
Fischer Black, The Dividend Puzzle, 2 J. PORTFOLIO MGMT. 5, 7 (Winter 1976).
Whether the shareholders paid the corporation for their shares or whether they have simply
contracted to do so, their financial exposure with respect to any liabilities that the corporation may incur is
limited to the amount that they have paid the corporation or have agreed to pay for their equity. See
CHARLES R.T. O’KELLEY & ROBERT B. THOMPSON, CORPORATIONS AND OTHER BUSINESS ASSOCIATIONS,
CASES AND MATERIALS 157 (3d ed. 1999).
8
And in certain situations also other corporate constituencies.
9
See BAYLESS MANNING & JAMES J. HANKS, JR., LEGAL CAPITAL 5 (3d ed. 1990) [hereinafter
MANNING & HANKS]; Royce de R. Barondes, Fiduciary Duties of Officers and Directors of Distressed
Corporations, 7 GEO. MASON L. REV. 45, 48 n.9 (1998).
10
O’KELLEY & THOMPSON, supra note 7, at 566.
7
5
possible, that the corporation maintains a sufficient volume of assets throughout the life
of the debt.
Corporate law systems secure the objectives of the creditors, to some extent, by
imposing limitations on the power of corporate constituencies to carry out distributions.
At the same time, a delicate balance must be preserved between the interests of the
creditors and that of the equity owners. A corporate law system that overprotects
creditors might become a less attractive choice of domicile for investors.
The availability of distributions becomes a main consideration weighing with
investors as they decide where to incorporate their business. Furthermore, it has been
observed that increased legal certainty and predictability attract global capital, and
produce benefits for the domestic economy.
This thesis pauses to consider the achievements and shortcomings of the corporate
legal systems of both Israel and Delaware, U.S.A., as they address the issue of corporate
distributions to shareholders. The thesis considers the 1999 corporate law reform in
Israel, and reviews the significance of dividends and stock repurchases in the
management, development, and survival of the corporate enterprise.
While common law remains as the base of Israeli corporation law, the Israeli legal
system is influenced by other common law jurisdictions, particularly by U.S.
jurisdictions. From the standpoint of comparative law, Delaware’s corporation law,
which is renowned for being an attractive choice of domicile for businesses, serves an
excellent basis for comparison.
6
III.
Israel’s Corporate Law System
Israeli corporation law derives primarily from English law. From 1917, until the
declaration of the State of Israel in 1948,11 Israel (then named “Palestine”) was subject to
a British mandate. During the British rule, various laws were enacted encompassing a
broad array of commercial decrees, including company laws. When instituting
commercial decrees, the British High Commissioner drew upon the English law, making
only minor changes. The Companies Ordinance,12 enacted in 1929, was virtually a replica
of the English Act of Parliament. As a common law jurisdiction, the existing English
common law served as the basis for applicable precedent.
To prevent the creation of a legal “vacuum” subsequent to the establishment of
the State of Israel, the parliament announced that mandatory laws, which were not averse
to the fundamental principles of the newly founded state, would remain in force.
Inevitably, the Companies Ordinance, which was ratified upon the foundation of Israel,
was copied in its entirety from the English Companies Act. It was extensively amended,
though, in 1983,13 until it was replaced with a new cohesive corporate code in 1999, the
Companies Law.14
11
On November 29th, 1947, the United Nations General Assembly passed a resolution calling for
the establishment of the State of Israel. On May 14, 1948, on the day in which the British Mandate over
Palestine expired, the State of Israel was officially declared.
12
“An ‘ordinance’ is a term used to describe a statute promulgated in Palestine, under the British
Mandate, by the mandatory High Commissioner. Although ordinances are, by and large, administrative
decrees, they are regarded as normal statutory materials and enjoy the same hierarchical status as later
parliamentary laws passed by the Knesset [Israel’s parliament].” Uriel Procaccia, Crafting a Corporate
Code from Scratch, 17 CARDOZO L. REV. 629, 629 n.1 (1996).
13
PKUDAT HA’HAVAROT (NOSAH HADASH) [The Companies Ordinance (New Version)], 1983
[hereinafter The Companies Ordinance (1983)].
14
HOK HA’HAVAROT [The Companies Law], 1999, S.H. 189 [hereinafter The Companies Law,
1999].
7
The new Companies Law was an attempt to fine-tune Israel’s corporation laws
with global commercial trends. One aspect that the new Companies Law attempted to
address was the conditions upon which distributions are made to shareholders. The
Companies Ordinance, 1983, contained rigorous rules against distributions. As a general
rule, the Companies Ordinance prohibited distributions, with some exceptions. The new
Companies Law, contrary to the Companies Ordinance, generally authorizes
distributions, with few limitations.
However, in attempting to resolve a series of ongoing uncertainties regarding
dividends and share repurchases, legislators have managed to generate further
uncertainty. Although some of the changes designed to alleviate the strictures on
distributions were well needed, others remain particularly inflexible as compared with
parallel laws elsewhere.
IV.
Thesis Structure
Imposing restrictions on corporate distributions is one of the primary solutions
offered by corporation codes for the conflict of interest between equity holders and
debtholders.15 Chapter 2 of the thesis examines the conflict between debt and equity and
its manifestation in investment theories. It is suggested that because shareholders and
debtholders share risk asymmetrically, shareholders of leveraged firms have a liking for
high-risk ventures, particularly when the corporation is near or on the verge of
15
The thesis focuses on the disposition of unsecured creditors. A secured creditor is one who has
extracted some type of “collateral” from the corporation. Thus, the interest of the secured creditor lies in a
particular asset, which the corporation may not dispose of voluntarily without the consent of the creditor.
Where the corporation’s assets are insufficient to pay all outstanding claims (secured and unsecured),
general creditors may be left unpaid, while secured creditors will receive payment owing to them to the
extent of their security prior to all other creditors. The general creditors have no claim against the value of
the secured assets except to the extent that the value of the secured assets, exceed the secured creditor’s
claim. MANNING & HANKS supra note 9, at 6.
8
insolvency. Chapter 2 further considers the mechanisms for eliminating investment risks
and the significance of the equity cushion in that process.
Chapter 3 of the thesis focuses on the legal capital rules which shape, to a large
extent, the provisional limitations on distribution. The rules of the legal capital model
address the questions of how much, and under what circumstances, may corporate
treasury assets be distributed to shareholders. Chapter 3 examines several distributionoriented provisions and their effect on corporate constituencies.
Chapter 4 critically evaluates the effectiveness of the legal capital model in
protecting creditors’ interests, versus the strain they impose on the corporation and other
constituencies.
Chapter 5 considers the vital role that dividends and share repurchases play in
commercial planning. We revisit the most reiterated financial theories and legal criticisms
over the role of dividends and share repurchases in the vitality of corporations.
The analysis in Chapter 5 provides the setting for appreciating the legal
developments that Israel experienced during the 1999 legal reform, fully examined in
Chapter 6. We compare in Chapter 6 the statutory disposition of Delaware corporations
and Israeli corporations, and consider the impact that Delaware case law might have on
legal interpretation in Israel. Chapter 6 mainly considers the legitimacy of several
methods of repurchases and breaches of directorial duties.
Finally, Chapter 7 examines the scope of liability that Israel and Delaware impose
on shareholders and directors for improper distributions, and the extent to which creditors
can impede distributions that have a negative effect on their status.
9
CHAPTER 2
THE CONFLICT OF INTEREST BETWEEN THE SHAREHOLDERS
AND THE CREDITORS
I.
Introduction
Theories on legal capital16 and the corporate enterprise have long recognized the
tension between shareholders and creditors, whenever debt is issued to the corporation.17
These theories propose that once the corporation is leveraged, shareholders have an
interest in minimizing the quantity of assets to be committed to the corporation’s
treasury, and in maximizing the volume of distributions from the corporate treasury.18
Because of the legal structure of the corporation, whereby the shareholders’
liability and risk are limited to their investment,19 the creditors of the corporation seek
reasonable assurances from the corporation that it will have sufficient assets towards the
payment of their claims when they become due. Having lent the corporation money, the
creditors would generally like the corporation to maximize its pool of assets and secure
them throughout the life of the debt.
16
For and extensive review of the legal capital model see discussion infra pp. 18-26.
Barondes, supra note 9, at 48 n.9.
18
MANNING & HANKS supra note 9, at 5; Barondes, supra note 9, at 48.
19
See O’KELLEY & THOMPSON, supra note 7, at 157:
17
Normally, a shareholder has no obligation or liability to the corporation or its
creditors beyond the amount she paid for the shares. This concept, known as
“limited liability”, allows a shareholder to risk only a predetermined amount
of capital in each corporate investment, instead of potentially risking her
entire wealth as would be the case if shareholders were personally liable for a
corporation’s debts.
9
10
II.
The Conflict Between Debt And Equity
Finance theories highlight three predominant differences between debt and
equity: the nature of the claim as fixed or residual, repayment priority, and the
governance rights associated with each.
The shareholders of the corporation are not the owners of the corporation’s
property, but have the right to share in the earnings of the corporation, as they may be
declared in “dividends”.20 Upon dissolution the shareholders are entitled to a
proportionate share in the residual assets of the corporation.21 Thus, while the
shareholders collect the full upside of their investment (after the lenders are repaid),
they must accept the downside of a poor investment. If no income remains after the
lenders are reimbursed, the equity holders receive no return and lose their invested
capital.
The creditors of the corporation lend the corporation funds and contract to
receive the repayment of the principal plus an agreed rate of interest. Regardless of the
prosperity that the corporation may enjoy, lenders, as fixed claimants, will be entitled
only to the repayment of a fixed amount.
20
For the term “dividend” see DEL. CODE ANN. tit. 8 § 170 statutory notes (2001)- Penington v.
Commonwealth Hotel Constr. Corp., 17 Del. Ch. 394, 155 A. 514 (1931) (“Payment to stockholders as
return upon their investment is, in general, termed a dividend . . . . Dividend is the sum of money or portion
of divisible thing to be distributed according to some fixed scheme.”), and see id. Bryan v. Aikin, 10 Del.
Ch. 446, 86 A. 674 (1913):
The stockholder does not, and cannot, own the property of the corporation, or
even the earnings, until they are declared in the form of dividends, but when
they are so declared, whether in cash, or in stock purchased or newly created,
they are not capital of the company, but a distribution of profits which were
made by the use of the corporation' s capital in the prosecution of its business.
21
Equity investors contract to receive the remaining income of the firm after expenses, taxes, debt
installments, and after higher priority claims are satisfied.
11
In terms of priority,22 an equity investment affords the shareholders a claim to
share in the assets and net income of the corporation, after expenses, taxes, and higherpriority obligations are paid.23 Equity investors may receive periodic payments in the
form of dividends, pro rata to their investment share. Such periodic payments are
voluntary and have no maturity date. Compared to debt, an equity interest is viewed as a
more risky investment because it awards dividends only after all higher-priority claims
are repaid.24
Debt has an absolute repayment priority over equity. It is a fixed sum with a
maturity date.25 In the event of dissolution, shareholders are last in line to collect.
However, while the creditors’ position in the hierarchy of claim is superior to the
shareholders, the creditors must still compete among themselves for priority in the right
of payment.26
As a result, in the absence of a special agreement with the corporation, the
disposition of individual creditors will be adversely affected by an increase in the
22
“Priority” in the sense of hierarchical disposition.
O’KELLEY & THOMPSON, supra note 7, at 566.
24
Equity is considered more risky than debt for various reasons of which two are central. First,
any return on equity, either through the resale of securities or periodic payments, is uncertain. In contrast to
debt investments, where the investment yields a fixed return, the return from an equity investment varies
with the fortunes of the firm. By definition, then, equity returns have a greater variance or range of
expected returns than the returns associated with a debt investment. The greater the variance of a project,
the less the project is worth to the typical risk-averse investor. See RONALD J. GILSON & BERNARD S.
BLACK, THE LAW AND FINANCE OF CORPORATE ACQUISITIONS 80-87 (2d ed. 1995) (hereinafter GILSON &
BLACK).
25
Typically, repayments are made in equal installments until the debt is finally repaid at a
specified date, rather than as a lump sum at maturity date.
26
Lenders have an automatic right to payment before the next most junior claim may be paid.
MANNING & HANKS supra note 9, at 6:
23
Creditors compete among themselves for an interest in specific assets of the
debtor, and to the extent they are unable to achieve a fully - secured position,
for priority in right of payment. The corporate debt may consist of several
classes of undertakings differently ranked relative to one another. Some
claims may be subordinate to some or all other claims of specific creditors or
classes of creditors.
12
aggregate outstanding claims against the debtor corporation.27 Furthermore, as the
leverage of the firm increases, so does the likelihood of bankruptcy.
In order to secure their position in the collection procession, creditors may require
the corporation to afford them the position of a “senior debtor”, to which all other claims
or classes of claims are subordinate, i.e. “junior”. Naturally, the ability of a creditor to
extract such a commitment from the corporation is susceptive to a competitive market.
Prior to the purchase of the debt, the shareholders of the non-leveraged firm share
the upsides of their investment while their risk is limited to their initial contribution. If
the enterprise is unsuccessful, these initial contributions would be used to pay for the
corporation’s outstanding obligations. While shareholders’ appetite for risk may vary
according to personal preferences28 and depending on the category of the corporation,29
they will arguably be less pronged to take risky projects that could place their investment
at risk of loss.
Debtholders will negotiate the terms of the debt30 to reflect their view on the risk
of default according to the financial well-being of the corporation at the point of
negotiations. Arguably, they will have already taken into consideration management’s
and shareholders’ expected behavior, following the issue of the debt.
27
Claim dilution, or the later issuance of the same or higher-priority debt, is an agency cost
associated with debt. As more debt of the same or higher priority is issued, the value of the original debt
decreases due to the heightened risk of nonpayment. Lenders can protect against claim dilution by
demanding a security interest in the debtor’s assets or by requiring covenants restricting the subsequent
issuance of equal or higher-priority debt.
28
On risk aversion see GILSON & BLACK, supra note 24, at 80-87.
29
On closely held corporations see Barondes, supra note 9, at 51 n.16 (a closely held corporation
may be formed for the purpose of assuming a risky project depending on the averseness of the members to
risk. Where the members are not risk averse they may prefer devising the risk between a small group of
members and enjoy, if the project is successful, higher percentages of profit. Public investors share a small
portion in the downfall and as a result may be more willing to take riskier projects while large block
holders may be more risk averse).
30
E.g., interest rate and period of debt.
13
i.
Overinvestment theory
Legal capital theories suggest that once debt has been sold to the corporation, the
return to shareholders for pursuing risky strategies increases by virtue of the
disproportionate allocation of risk between the shareholders and debtholders.31 The
shareholders of a highly leveraged firm get all of the increased upside potential from
taking a large risk. Much of the increased downside is borne by the debtholders.
Gilson and Black provide a helpful analysis of the conflict between debt and
equity by applying the options perspective.32 When a firm purchases debt, the
shareholders can be seen as having sold and non-leveraged firm to the debtholders in
return for the proceeds from issuing the debt, and a call option to repurchase the nonleveraged firm by paying off the debt.33 The value of the shareholders’ call option on the
debt is determined by the variance (measure of risk) in the future value of the firm. The
higher the variance, the greater the expected return, but so too the expected loss. Since
shareholders’ liability is limited to their stock contribution, high variance projects shift a
predominant part of the risk (depending on how leveraged the firm is) to the bondholders.
31
Daniel R. Fischel, The Economics of Lender Liability, 99 YALE L.J. 131 (1989) (hereinafter
Fischel, Lender Liability). See also Brent Nicholson, Recent Delaware Case Law Regarding Director’s
Duties to Bondholders, 19 DEL. J. CORP. L. 573, 585-86 (1994) (discussing Chancellor Allen’s opinion in
the landmark case of Credit Lyonnais Bank Netherland, N.V. v. Pathe Communications Corp., Civil Action
No. 12150, 1991 Del. Ch. LEXIS 215 (Del. Ch. Dec. 30, 1991)):
In footnote 55, Chancellor Allen discussed the tension that sometimes exists
between creditors and shareholders, particularly when insolvency threatens
the corporate existence. For instance, shareholders may desire higher risk
strategies that reduce the certainty of having funds available to pay the
debtholders. Debtholders, however, clearly would prefer a management
policy which preserves funds sufficient to pay the corporate debt.
32
On options see generally GILSON & BLACK, supra note 24, at 231-43.
Id. at 244. On the repayment date, if the firm’s assets exceed the repayment price, the
shareholders will “exercise their option” to repurchase the non-leveraged firm by repaying the debt. If the
value of the firm’s assets is lower than the repayment price, the equity holders will not exercise their option
(by defaulting on the debt).
33
14
Gilson and Black provide a very helpful illustration on how the factors that
determine the option value affect the incentives of both parties:
Suppose that firm X has assets of $100, all invested in
Treasury bills, and outstanding debt of $90. If the firm keeps its
funds in treasury bills, it will be able to pay the debt for sure, so
the debt will be worth $90 and the stock will be worth $10.
Suppose though that the stockholders find a project that requires
a $100 investment, and has a 50% chance of returning $200 and
a 50% chance of returning $0. The expected return on the $100
investment is $100.
The expected payoff to the stockholders from this investment
is strongly positive. If the investment pays off, they repay the
debt and are left with stock worth $110. If the investment
doesn’t pay off, the stockholders default on the debt and are left
with $0. Since both outcomes are equally likely, the expected
payoff is $55 . . . .
Stock value
Debt Value
Firm Value
Before Risky
Investment
$10
$90
$100
After Risky Investment34
(.50 x $110) + (.50 x $0) = $55
(.50 x $90) + (.50 x $0) = $45
(.50 x $200) + (.50 x $0) = $100
The stockholders’ gain, though, is the debtholders’ loss. If the
investment pays off, the debtholders receive $90. If the
investment doesn’t pay off, they are left with a claim on a
worthless firm, worth $0. Since both outcomes are equally
likely, the expected payoff is $45.35
Gilson and Black conclude that the shareholders have an incentive to cause the
firm to take riskier investments than would otherwise be optimal for a non-leveraged
firm.36
Thus, when the equity of the firm is small, as in the instance where the value of
the firm equals its outstanding debt, the debtor has nothing to lose, and everything to
34
The expected return on a project under uncertainty is the expected return upon success
multiplied by the probability of success, plus the expected return upon failure multiplied by the probability
of failure.
35
GILSON & BLACK, supra note 24, at 245.
36
Id. at 244.
15
gain, from engaging in high-risk projects.37 If the strategy succeeds, the shareholders will
reap most of the benefits vis-à-vis the rise in the market value of the firm. If the strategy
fails, the market value of the firm will fall, but the creditors will bear the loss.
ii.
Underinvestment theory
The incentives of equity holders to cause the corporation to enter into high risk
ventures fortifies when the corporation is near or on the verge of insolvency.38 On the
other hand, some argue that an insolvent firm will in fact under-invest in projects, i.e.,
due to indifference, the firm will fail to enter into transactions that would be valueincreasing.39 The theory is that shareholders will not invest equity, or make the efforts
necessary, for the firm to take positive net present value projects. This is because the
returns will be realized not by the shareholders but by the creditors, unless, of course, the
returns from the project are expected to exceed the value of the debt. The heavier the
leverage, the more likely the aforementioned behavior will occur.
III.
Eliminating Investment Risks And The Function Of The Equity
Cushion
Ultimately, both the debtors and the creditors have a mutual interest in producing
a profit, and both wish to risk as little as possible in the process.
37
Fischel, Lender Liability, supra note 31, at 134.
See Barondes, supra note 9, at 49 n.10 for a discussion on the subject of insolvency. See also
discussion infra pp. 78-79. For the proposition that the incentive to pursue risky investment strategies
increases at insolvency or near insolvency see Fischel, Lender Liability, supra note 31, at 134; Barry E.
Adler, A Re-Examination of Near-Bankruptcy Investment Incentives, 62 U. CHI. L. REV. 575, 576-77
(1995); Katherine H. Daigle & Michael T. Maloney, Residual Claims in Bankruptcy: An Agency Theory
Explanation, 37 J.L. & ECON. 157, 157 (1994) (stating that shareholders’ incentives to engage in excessive
risk-taking are “particularly acute” when the firm is distressed); Barondes, supra note 9, at 49 (“These
incentives can become very powerful for a corporation approaching insolvency, because the shareholders
may essentially be indifferent as among all outcomes involving a non-positive return, negative returns of a
distressed corporation being almost entirely borne by the creditors.”).
39
Daniel E. Ingberman, Triggers and Priority: An Integrated Model of the Effects of Bankruptcy
Law on Overinvestment and Underinvestment, 72 WASH. U. L.Q. 1341, 1342 (1994); Fischel, Lender
Liability, supra note 31, at 134-35.
38
16
Since equity owners cannot be held accountable for liabilities exceeding their
initial contributions, then theoretically, shareholders could eliminate their risk by causing
the corporation, subsequent to its acquisition of debt, to distribute to them assets in the
value of their investment. Arguably, ensuring that enough assets remain in the firm to
satisfy the creditors’ claim protects the creditors’ interests.40 The value of the
shareholders’ investment is sometime referred to as the creditors’ “equity cushion”.41 The
larger the equity cushion of the firm, the lower the risk of loss to the lender upon default,
because lenders have the first claim on the firm’s remaining assets, including the equity
cushion.
As illustrated above, once the debtor decreases the equity cushion (through asset
withdrawal),42 the debtor has the incentive to increase the risk of the venture, because
he/she will capture the upside of a risky project while nearly the entire downside, such as
losses associated with bankruptcy, will fall on the lender.43 The creditors would like to
receive at least a reasonable assurance that the corporation’s common shareholders will
not be paid before them, in the sense that the shareholders receive money from the
corporation, while the creditors are left with an unpaid claim against an insolvent
corporation. Without the constraints of the law, the shareholders could theoretically
40
See Fischel, Lender Liability, supra note 31, at 135; WILLIAM A. KLEIN & JOHN C. COFFEE, JR.,
BUSINESS ORGANIZATION AND FINANCE: LEGAL AND ECONOMIC PRINCIPLES 240-41 (5th ed. 1993);
JOSEPH GROSS, HOK HACHAVAROT HACHADASH [The New Companies Law] 331-32 (2d ed. 2000) (Isr).
See also C.A. 39/80, Berdigo v. D.G.B. 9 Textile Ltd., 35(4) P.D. 197, 222 (S. Ct. Isr.) (Justice Barak
explains the significance of the equity cushion stating that because of the shareholders’ limited liability, the
only security a creditor has its corporate assets. Therefore, it is essential to ensure that the capital of the
corporation will remain a basis for the settlement of corporate debts and not be dispersed to the
shareholders, if through dividend distribution or another manner).
41
See id.
42
An example of asset withdrawal is the distribution of funds just issued to the firm in the form of
dividends.
43
KLEIN & COFFEE, supra note 40, at 53-62 (an important form of security for the creditor is the
assurance that the owner has significant assets at risk. Such an owner will have every incentive to make the
business profitable).
17
reduce their investment risk by draining the corporation of their initial investment (and
possibly other corporate assets) and distributing the money back to themselves, after the
corporation had taken on debt. Without legal limitations, the shareholders could
effectively move themselves up the line for collection, preceding the creditors. This
would essentially undermine the principles of the collection chain.
Out of the conflict between the creditors’ desire to keep corporate assets from
being distributed to shareholders, and the shareholders’ desire to do exactly that (despite
the existence of outstanding debt or arguably because of it), legal capital provisions have
emerged.44
44
MANNING & HANKS, supra note 9, at 16.
18
CHAPTER 3
LEGAL CAPITAL RULES AND THE EQUITY CUSHION
I.
Introduction To The Legal Capital System
Legal capital rules were originally developed to protect third party creditors.45
These rules were intended to assure creditors that, despite shareholders’ limited liability,
the corporation would maintain a certain amount of “permanent capital”.46 This
permanent capital provides, at least in theory, an equity cushion, thereby protecting
creditors by restricting the right of shareholders to withdraw funds from the corporation.
At the same time, Delaware and Israel corporation laws did not generally require
corporations to demonstrate a minimum of capital to incorporate.47 The absence of such
requirement is understandable considering the fact that the purpose of the restrictions
placed on asset withdrawal, was to minimize the creditors’ risk associated with the failure
of the business.48
Understandably, creditors want the corporation to preserve a cushion of protective
assets so that claimants who rank junior to them could not draw assets from the
45
Id. at 12; O’KELLEY & THOMPSON, supra note 7, at 567; GROSS, supra note 40, at 331.
Fischel, Lender Liability, supra note 31, at 135; KLEIN & COFFEE, supra note 40, at 240-41;
GROSS, supra note 40, at 331-32; Berdigo, 35(4) P.D. at 222 (Justice Barak emphasizes the significance of
the equity cushion as a source of creditor security in stating that, because the shareholders enjoy limited
liability, the corporation should be required to maintain a minimum permanent capital to secure the
interests of the creditors).
47
YECHIEL BAHAT, THE NEW CORPORATE ISRAELI LAW 438 (1999) (Isr.). I must be noted,
however, that with respect to certain industries, such as insurance, banking etc., there are specific
requirements of minimum legal capital.
48
But see David Han, Haluka Leba’alei Menayot Ve Shmirat Hon, He’ara Lehatza’at Hok
Hahavarot [Distribution to Shareholders and Maintaining the Capital, Comment on the Companies Bill],
A(3) SHA’AREI MISHPAT 313, 314-15 (June 1998) (Isr.) (criticizing the importance of the equity as a
protective asset to creditors).
46
18
19
corporation, while their claim is still outstanding and unpaid. Therefore, funds paid to the
corporation in consideration for the purchase of shares are to become the permanent
capital of the corporation, which cannot be distributed to the shareholders until all claims
have been fully paid.
Legal capital doctrines reflect nineteenth century principles.49 In the landmark
case of Wood v. Dummer50Justice Story noted that,
During the existence of the corporation [the capital stock] is the
sole property of the corporation, and can be applied only
according to its charter, that is, as a fund for payment of its
debts, upon the security of which it may discount and circulate
notes. Why, otherwise, is any capital stock required by our
charters? If the stock may, the next day after it is paid in, be
withdrawn by the stockholders without payment of the debts of
the corporation, why is its amount so studiously provided for,
and its payment by the stockholders so diligently required? To
me this point appears so plain upon principles of law, as well as
common sense, that I cannot be brought into any doubt, that the
charters of our banks make the capital stock a trust fund for the
payment of all the debts of the corporation. The bill-holders and
other creditors have the first claims upon it; and the stockholders
have no rights, until all the other creditors are satisfied. They
have the full benefit of all the profits made by the establishment,
and cannot take any portion of the fund, until all the other claims
on it are extinguished. Their rights are not to the capital stock,
but to the residuum after all demands on it are paid.
Justice Story construed the shareholders’ contributions as a “trust fund” for the
payment of all the bank’s debts. Nineteenth and early twentieth century trust fund theories
were based on the premise that whatever values had originally been paid for shares, should
be maintained until such time as all outstanding claims have been paid in full.51
49
MANNING & HANKS, supra note 9, at 20 (“The legal capital scheme contained in our modern
corporation codes is the direct product of nineteenth century legal history. Legal capital provisions are
comprehensible (to the extent that they are comprehensible at all) only in the context of that history.”).
50
30 F. Cas. 435 (C.C.D. Me. 1824).
51
Craig A. Peterson & Norman W. Hawker, Does Corporate Law Matter? Legal Capital
Restrictions on Stock Distributions, 31 AKRON L. REV. 175, 180 (1997); According to Manning and Hanks
20
Similarly, Israel’s legal capital rules originate from nineteenth century English
law. In the case of Berdigo v. D.G.B.,52 Justice Barak noted that the doctrine, which
prohibits the reduction in capital, originates from English case law, which set out to
assure that creditors have an equity cushion on which they can rely, in face of the
shareholders’ limited liability.53 Justice Barak went on to cite from Justice Jessel’s
opinion, in the 1881 English case of In re Exchange Banking Co., Flicoft,54 where he
stated that,
The creditor has no debtor but that impalpable thing the
corporation, which has no property except the assets of the
business. The creditor, therefore, I may say, gives credit to the
company on the faith of the representation that the capital shall
be applied only for the purpose of the business. And he has
therefore a right to say that the corporation shall keep its
capital and not return it to the shareholders.
Because current provisions pertaining distributions are, in both Delaware and
Israel, the product of nineteenth century jurisprudence, it is debatable whether they
prove suitable in defeating problems arising out of the modern shareholder-creditor
conflict.55
i.
Par Value
At the heart of early general corporation laws containing legal capital
provisions, was the concept of “par value”.56 Apart from its original purpose,57 par
the entire range of legal capital doctrines can be traced to Justice Story’s decision in Wood v. Dummer. See
MANNING & HANKS, supra note 9, at 30-31.
52
Berdigo, 35(4) P.D. 197.
53
See id. at 222.
54
[1881] 21 Ch. D. 519, 533 (C.A.).
55
Legal capital theories have been long criticized as complex, vague and unsuitable.
56
For the development of the concept par value see O’KELLEY & THOMPSON, supra note 7, at
568. Israel’s Companies Ordinance, 1983, which preceded the Companies Law, 1999, already recognized
the concept of par value from English jurisprudence.
57
Originally, par value was introduced as a solution to the problem of assuring equitable
contribution among shareholders. Par value developed into a legal minimum of what a shareholder ought to
pay for his or her stock. MANNING & HANKS, supra note 9, at 24.
21
value has developed as an instrument in furthering the interest of creditors, by
securing the shareholders assets within the corporation.
Early corporation codes determined the legal capital of corporations simply by
multiplying the number of outstanding shares times the value of those shares. The
result was, incidentally, the specified par value of the shares.58 Early provisions,
which sought to restrict asset distributions, further relied on the premise that par value
was equal to the purchase price of stocks.59 During this era, where all shares had par
value60 and most were presumably issued at a price equal to par value, the concept of
legal capital had a certain economic significance. Legal capital was conventionally
equal to the value created by the issue of stock and became an indicator for the
creditors as to the size of the corporation’s equity cushion. This scheme was
disrupted, however, with the introduction of penny-par stock61 followed by no-par
stock.62
58
O’KELLEY & THOMPSON, supra note 7, at 568 (“[C]orporation law required all shares to have a
par value, and custom required that shares be issued for an equivalent price . . . . ”).
59
Id.
60
Melvin Aron Eisenberg, The Modernization of Corporate Law: An Essay for Bill Cary, 37 U.
MIAMI L. REV. 187, 199 (1983). (“Modern statutes, however, do not require that shares have a par value,
and even shares that have a par value may carry a par value much lower than the price at which they are
issued.”). Israel has only recently facilitated the issuance of stock having no par value. See The Companies
Law, 1999, 34, S.H. 189.
61
For instance, a corporation may issue shares having a low par value of less than $1 and yet sell
such shares to the public for higher value.
62
No-Par stocks are stocks that have an arbitrary value assigned to them by the board of directors.
They are thus different from par value stocks that have a stated value. And see Eisenberg, supra note 60, at
199. (“[T]he economic capital generated by the issue of stock may be much greater than the corporation' s
legal capital, which has become a mere legal construct determined in a wholly arbitrary manner.”);
O’KELLEY & THOMPSON, supra note 7, at 569:
[I]n the twentieth century, however, both law and custom changed. Investors
came to accept that there was no necessary connection between par value and
issue price. This it became common for crop to offer shares to the public at a
price far in access of the par value selected for such shares.
22
ii.
No-Par Stock
The introduction of no-par stock63 did not eliminate the concept of legal capital.
However, since it was no longer possible to determine the permanent legal capital (the
equity cushion) simply by multiplying the number of shares issued times the par value,
the corporation’s board of directors had to declare its dollar amount. Such dollar number
was to be known either as the “stated capital” or the “legal capital” of the corporation.
Israeli corporation law continues to refer to legal capital as “stated capital”, and
Delaware’s G.C.L.64 simply as “capital”.
The stated capital represented the stockholder’s permanent investment in the
corporation and served the same function as par value, insofar as it represented the
minimum issue price and the minimum, permanent, amount of the corporation’s net
assets. At the same time, stated capital provided the corporation with a great deal more
flexibility in issuing stocks.
Nowadays, the directors of a Delaware corporation which issues no-par stocks,
may determine by resolution and in accordance with section 154 of the Delaware
G.C.L.,65 what part of the consideration received by the corporation for any of the shares
63
In Israel no par stocks were introduced only in the 1999 version of the Companies Law in
section 34.
64
Delaware corporation laws are governed by the Delaware General Corporation Laws
(hereinafter Delaware G.C.L.).
65
DEL. CODE ANN. tit. 8 § 154 (2001):
Any corporation may, by resolution of its board of directors, determine that
only a part of the consideration which shall be received by the corporation for
any of the shares of its capital stock which it shall issue from time to time shall
be capital; but, in case any of the shares issued shall be shares having a par
value, the amount of the part of such consideration so determined to be capital
shall be in excess of the aggregate par value of the shares issued for such
consideration having a par value, unless all the shares issued shall be shares
having a par value, in which case the amount of the part of such consideration
so determined to be capital need be only equal to the aggregate par value of
23
of its capital stock will be designated as capital. The directors may later transfer
the remaining part of the consideration, with some limitations, outside of the
capital
account,
and
under
certain
circumstances
distribute
it
to
the
shareholders. 66
Accordingly, where the actual purchase price exceeds the par value, the
paid in capital is separated into stated capital (the aggregate par value of the
outstanding shares) and capital surplus (the excess amount).
For example, the shareholders may have paid $100 for each share in the
corporation, while the par value of those shares, as determined by the board of
directors, was only $40 each. The difference between what the shareholders paid
for their shares at the time they were originally issued, and the stated capital
represented by those shares, is credited to the capital or paid-in-surplus
account.
such shares. In each such case the board of directors shall specify in dollars the
part of such consideration which shall be capital . . . .
...
The amount of the consideration so determined to be capital in
respect of any shares without par value shall be the stated capital of such
shares. The capital of the corporation may be increased from time to time by
resolution of the board of directors directing that a portion of the net assets of
the corporation in excess of the amount so determined to be capital be
transferred to the capital account. The board of directors may direct that the
portion of such net assets so transferred shall be treated as capital in respect
of any shares of the corporation of any designated class or classes. The
excess, if any, at any given time, of the net assets of the corporation over the
amount so determined to be capital shall be surplus. Net assets means the
amount by which total assets exceed total liabilities. Capital and surplus are
not liabilities for this purpose. (emphasis added)
66
See id. § 244.
24
Assuming that the corporation has issued 1,000 shares, its balance sheet will look
as follows:
Assets
Cash
Inventory
40,000
70,000
Liabilities and Shareholders Equity
Total Liabilities
Shareholders’ Equity
Stated Capital
Capital Surplus/ Paid-in Surplus
Retained Earnings/ Earned Surplus
110,000
10,000
40,000
60,000
110,000
In Israel no-par stocks were only introduced in the 1999 version of the Companies
Law.67 Beforehand, Israeli corporate law recognized par value stocks only. The change
was prompted (as it did in the U.S.) by a growing recognition that the strictures that set
the historical value of stocks, were rapidly vanishing. The value of stock was no longer
tied to the stated/nominal value assigned to it by the shareholders, but rather by real
values set by the market.
Nevertheless, even under the new version of the Israeli Companies Law, the
legislator proscribed the issuance of par value stocks along with no-par stocks.68 In sharp
contrast, the parallel provision in the Delaware G.C.L., does authorize the issuance of
both no-par and par-value stocks, in a single enterprise.69
Furthermore, in contrast to Delaware, the introduction of no-par stocks into Israeli
corporation law did not broaden the means by which Israeli corporations could engage in
asset dispersion. In fact, the introduction of no-par stocks did nothing in this respect.
67
The Companies Law, 1999, 34 S.H. 189.
The Companies Law provides that the stocks of a corporation may be either par value stocks or
no par stocks. A single corporation may not have par stocks and no par stocks along side. See id. See also
BAHAT, supra note 47, at 419.
69
DEL. CODE ANN. tit. 8 § 102(4) (2001).
68
25
Israeli corporations are still bound to preserve any and all paid-in share capital.70 Thus,
while Delaware corporations may determine by resolution what part of the
consideration will be deemed “capital”, for Israeli corporations, the stated capital
proper, is the value of its par-value shares and other paid-in share capital, including
premiums. 71
Both jurisdictions stipulate that the stated capital of the corporation is the
permanent capital of the corporation.72 As such, it will be the last asset remaining for
distribution if, and once, the corporation exhausts all of its resources to cover its
debts.73
The Delaware G.C.L., section 154, appears to provide extensive liberty to
boards of directors in defining the equity cushion. Any ability the board may have to
manipulate this scheme is thought to be limited by the minimum requirements in that
section. For the purpose of identifying the equity cushion, the same section 154
provides that, where the corporation issues shares having a par value, the amount
designated as capital, may not be less than the aggregate par value of these shares.
When read in conjunction with the requirement of section 153 (that shares with par
value be sold for at least that amount),74 section 154 appears to identify the equity
cushion for the creditors.
70
The Companies Law, 1999, 302(b) S.H. 189. Compare with DEL. CODE ANN. tit. 8 § 244
(2001).
71
A “premium” is defined in section 1 of The Companies Law as any consideration received in
exchange for shares that exceeds the par value of those shares. The Companies Law, 1999, 1, S.H. 189.
72
See DEL. CODE ANN. tit. 8 § 154 (2001), and The Companies Law, 1999, 302 S.H. 189.
73
Han, supra note 48, at 315.
74
DEL. CODE ANN. tit. 8 § 153(a) (2001) (“Shares of stock with par value may be issued for such
consideration, having a value not less than the par value thereof . . . .”).
26
By the late 1960s, dissatisfaction with the entire scheme of legal capital was
evident in the U.S.75 By then, the doctrines of legal capital were wide spread. Most U.S.
states had already designed their corporate statutes based on legal capital concepts.76
Ultimately, increasing criticism is what led the majority of U.S. states to abandon the
legal capital doctrines.77 Oddly enough, both Delaware and Israel have continued to
embrace the legal capital model in their statutes.78
II.
Distributions And Their Effect On Creditors
A corporation normally distributes funds to its shareholders in one of two ways:
by paying a dividend, or by repurchasing/redeeming a portion of its stocks.
The corporation law, of both Delaware and Israel, generally limits the ability of
corporations to distribute their assets in a manner that reduces their capital, by applying
various tests that essentially center on preserving the legal capital.
75
See discussion infra chapter 4; MANNING & HANKS supra note 9, at 39 (arguing that legal
capital had changed from an identifiable set of assets contributed by the shareholders to an account with a
balance “arbitrarily” set at an amount equal to the par value multiplied by the numbers of shares
outstanding. Manning and Hanks write that legal capital “is initially the product of par value -- itself an
arbitrary dollar amount printed on the stock certificate and recited in the certificate of incorporation -multiplied by the number of shares ‘outstanding.’”).
76
MODEL BUS. CORP. ACT ANN. § 2, P2 (2d ed. 1971) (“These terms, or similar ones serving the
same function, are used in all corporate statutes in the United States today, although they are not always
defined.”).
77
(“In 1979, the Revised Model Business Corporation Act (“RMBCA”) jettisoned the “outmoded”
concepts of par value and stated capital set out in the MBCA in the apparent belief that traditional legal
capital doctrines were unduly complex, confusing and misleading.”) Peterson & Hawker, supra note 51, at
182-83, quoting The Committee on Corporate Laws, Changes in the Model Business Corporation Act -Amendments to Financial Provisions, 35 BUS. LAW. 1867 (1980) (“The amendments . . . reflect a complete
modernization of all provisions of the Model Act concerning financial matters, including . . . the
elimination of the outmoded concepts of stated capital and par value.”).
78
O’KELLEY & THOMPSON, supra note 7, at 568,
The legal capital restrictions based on par value continues to be near
universal feature of general corporation codes until 1980, when the ABA
Committee on Corporate Laws deleted such provisions from the Model
Business Corporation Act (MBCA). Delaware is among the minority of states
that continues to have legal capital rules in its corporation codes. The
remaining states, many of which follow the MBCA, restrict distributions to
shareholders but do not use the legal capital concept.
27
i.
Dividends From The Point Of View Of Creditors
Dividends are cash payments made by the corporation to its common
shareholders pro rata (in the same percentage).79 From the point of view of the
creditors, distribution of dividends lessens the amount of assets in the corporation that
potentially guarantees the payment of the debt. Such distributions cause a reduction in
the creditors’ equity cushion, since once money travels from the corporation to the
shareholders, it exits the pool of assets that would have otherwise been attainable by the
creditors in payment of their outstanding claims.
The legal rationale behind imposing limitations on corporations’ right to affect
distributions is twofold. Since the creditor has given up the opportunity to share in the
up-side of the business for a promise of a fixed return, and since the shareholders have
given up the right to a fixed return for an opportunity to share the proceeds of an upside, distributions to the shareholders prior to the payment of the debt, and at the
expense of the creditor, would unjustly reverse the parties’ basic understanding.
ii.
Repurchases From The Point Of View Of Creditors
A corporation’s repurchase of its own shares poses many of the same problems
posed by dividends. A repurchase is effectively a distribution of assets. The corporation
pays through its corporate assets for the return of its own shares.
79
Shareholders are not entitled to earnings of the corporation. They share in the earnings only
once they are declared as dividends. A dividends is “payment to the stockholders as return upon their
investment.” Penington v. Commonwealth Hotel Constr. Corp., 17 Del. Ch. 394, 155 A. 514 (1931). The
Companies Law, 1999 defines dividends as any asset given by the corporation to a shareholder, as a
shareholder, in cash or other consideration, including a transfer or a promise to transfer any, without equal
value consideration.” The Companies Law, 1999, 1, S.H. 189.
28
If the corporation were to repurchase shares pro rata from each of its
shareholders, it will experience the same economic effect as when distributing a
dividend. A repurchase that is not pro rata (i.e. where the corporation buys shares only
from some shareholders and not from others), may injure not only the creditors but also
other shareholders.80
While in Delaware share repurchasing is not a new practice, Israeli corporations
were prohibited from doing so up until the 1999 Companies Law. By authorizing share
repurchases, the legislator has shied away from the long abided English common law
rule that companies cannot acquire their own shares.
The prohibition on share repurchasing was established in the English case of
Trevor v. Whitworth (1887),81 on the grounds that such an acquisition would amount to
an unauthorized reduction of capital to the detriment of creditors.82 Following this rule,
Israeli corporations were prohibited from purchasing their own shares or assisting in the
purchase of corporate stock, directly or indirectly.83 This prohibition did not, however,
80
For example, a corporation repurchases shares from shareholder X at an above-market price. In
doing so, the corporation has depleted corporate assets to the detriment of the creditors and the shareholders
who have not had the chance to sell at the higher price. The shareholders and the creditors are now left with
a corporation worth less per outstanding share than before.
81
12 A.C. 409 (H.L.). The rule was never codified in the Companies Ordinance, 1983.
82
Id.
83
The Companies Ordinance § 139 (1983); Joseph Gross, Hahon Haatzmi Bahevra Kecarit
Habitahon Lanoshim – Hagana Amitit O Meduma? (Meah Shana Lehalachat Trevor), 13 IYUNEI
MISHPAT 439 (1988) [The Stated Capital of the Corporation as the “Creditors’ Equity Cushion” - A
Genuine or an Artificial Protection? (A Hundred Years Since Trevor)]; GROSS, supra note 40, at 351;
BAHAT, supra note 47, at 456 (section 308 provides that shares repurchased by the corporation will not
confer upon the corporation any rights while they are held by the corporation. In this manner we avoid the
absurd situation where a corporation is controlling itself, and competing against its shareholders in the
exercise of its rights. At the same time this facilitates the resale of stock in relatively short periods,
stabilizing stock prices.)
29
affect acquisitions made following a court’s approval84 or the calling in of redeemable
preference shares.85
Following a more global trend, the new Companies Law permits corporations to
repurchase their shares, subject to the general rules governing lawful distributions.86
As in the case of dividends, the ultimate effect of a repurchase is a decrease in
corporate assets with which the corporation could potentially pay its debts. Therefore,
modern statutes generally treat share repurchase in much the same way as they treat
dividends.
III.
Legal Limitations On Distributions
i.
Introduction
The corporation statutes of both Delaware and Israel focus on the impact of
wealth distributions on the capital of the corporation. The core objective of the
provisions limiting distributions in both statutes, was to protect the creditors of the
corporation from improper dissemination of corporate assets.87 The formula, however,
for making wealth distributions to shareholders was, and remains, ostensibly different.
First, while both jurisdictions stipulate that distributions be made out of
“profits” and “surpluses”, the definitions of these core terms share little resemblance.
84
Section 151 of the Companies Ordinance, 1983 enables a reduction of legal capital where
adjusting the capital structure would be beneficial to the well being of the business. At present, the court
may approve distributions that normally do not qualify under the regular tests set out in the Companies
Law. See The Companies Law, 1999, 303, S.H. 189 (distributions requiring court approval). For a complete
review see BAHAT, supra note 47, at 449. Furthermore, section 235 of the Companies Ordinance, 1983
enabled the purchase of minority interests by the company under a court order. This principle was
reiterated, with some changes in the Companies Law. See The Companies Law 1999, 191, S.H. 189. For a
complete review see BAHAT, supra note 47, at 449.
85
Providing that the corporation paid for them using profits or proceeds of a new issue. See The
Companies Ordinance §§ 141-143 (1983). And see The Companies Law, 1999, §§ 312-313 S.H. 189
(subsequent revisions).
86
The general rule being that distribution be made out of profits and does not render the
corporation insolvent. See GROSS, supra note 40, at 351.
87
DEL. CODE ANN. tit. 8 § 244 statutory notes (2001); GROSS, supra note 40, at 335.
30
Second, Delaware presents a more flexible and broad approach to
distributions. It endorses distributions made from unearned surpluses,88 some of
which are explicitly forbidden under Israeli law,89 and others that their legitimacy
remains unclear.90
A recent modification in the 1999 version of the Companies Law, which
underscores, perhaps, a more modern approach in Israeli legislation, is the
abolishment of the British provision, which subscribed stock repurchases.91
Clearly, the new Companies Law takes a different approach to distributions
than its English-based predecessor, the 1983 Companies Ordinance. The Companies
Ordinance generally prohibited any distribution which had the potential of reducing
the corporation’s capital, and which was not explicitly authorized. The Companies
Law, in sharp contrast, generally authorizes distributions with few exceptions.
Some critics argue that by setting marginal limits on the right to make
distributions,92 the new Companies Law has managed to provide clearer and more
uniform rules on lawful distributions.93 Others will argue that the attempt to lend
these rules more clarity was unsuccessful.94
88
See discussion infra p. 36.
The Companies Law forbids the distribution of any, and all, funds and premiums paid to the
corporation in consideration of stock. Furthermore, distribution must also qualify a second test, namely that
the distribution does not prejudice the company’s ability to pay its debts. The Companies Law, 1999, 302
S.H. 189.
90
See discussion infra p. 37.
91
See generally M. Freeman Durham, The Companies Act, 1980: Its Effects on British Corporate
Law, 4 J. INTL. L. BUS. 551, 562 (1982) (on the British common law rule prohibiting repurchases).
92
The Companies Law, 1999, 304(b) S.H. 189.
93
See GROSS, supra note 40, at 335.
94
See id.
89
31
ii.
Distributions From Surplus
Delaware law permits distributions drawn out of “surplus”.95 The law defines
surplus as the corporation’s net assets, less the aggregate par value of its shares (i.e.,
net assets less stated capital).96
According to section 244 of the Delaware G.C.L.,97 a surplus may be created
by,
[T]ransferring (i) some or all of the capital not represented by
any particular class of its capital stock; (ii) some or all of the
capital represented by issued shares of its par value capital
stock, which capital is in excess of the aggregate par value of
such shares; or (iii) some of the capital represented by issued
shares of its capital stock without par value.
Seeing as the outer limit on distributions is the stated capital,98 the directors of
a Delaware corporation may credit paid-in amounts, exceeding the par value, to a
capital surplus account (or paid in surplus account) from which they can subsequently
distribute dividends.
Thus, the Delaware G.C.L. focuses on the preservation of the legal capital
(presumed to be the creditors’ security), making any distribution that does not impair
the corporation’s capital, lawful.
95
DEL. CODE ANN. tit. 8 § 170(a)(2001):
The directors of every corporation, subject to any restrictions contained in its
certificate of incorporation, may declare and pay dividends upon the shares of
its capital stock, or to its members if the corporation is a nonstock
corporation, either (1) out of its surplus, as defined in and computed in
accordance with §§ 154 and 244 of this title . . . .
96
See id. § 154.
See id. § 244 (a)(4).
98
The consideration paid for the shares, not designated as capital.
97
32
This fundamental principle is clearly denoted in Delaware’s statutory notes of
section 24499 stating that,
[The] [r]equirement in this section that no reduction shall be
made in the capital stock of a corporation until all its debts are
paid means that the capital of the corporation, which is the
creditors’ security, shall not be impaired. State ex rel. RCA v.
Benson (citation omitted).
Furthermore, section 244(b) expressly limits the corporation’s ability to affect
changes on its capital that might devalue the corporate assets to the detriment of the
creditors, stating that “[n]otwithstanding the other provisions of this section, no reduction
of capital shall be made or effected unless the assets of the corporation remaining after
such reduction shall be sufficient to pay any debts of the corporation for which payment
has not been otherwise provided .”
Similarly, Israel’s 1999 Companies Law focuses on the effects of distributions on
the corporation’s capital structure. The Companies Law generally authorizes wealth
distributions to shareholders, providing that the stated capital of the corporation, also
regarded as the creditors’ security,100 will not be impaired,101 as well as providing that the
distribution will not spin the corporation into insolvency.102
In much the same way, the Companies Law allows distributions to be made out of
surpluses.103 However, the Companies Law then defines surplus in a materially different
way than its counterpart: as the corporation’s net undistributed profits104 (including
accumulated profits from the year of distribution and/or the preceding fiscal year)105 and
99
DEL. CODE ANN. tit. 8 § 244 statutory notes (2001).
Han, supra note 48, at 314.
101
The Companies Bill, explanatory notes, § 345.
102
The Companies Law, 1999, 302(a) S.H. 189 (regarding the second test).
103
The Companies Law, 1999, 302(b) S.H. 189.
104
As defined by acceptable accounting principles.
105
The Companies Law, 1999, 302(b) S.H. 189.
100
33
with the exclusion of any funds and premiums paid in return for stocks.106 This definition
clearly sets aside the stated capital amount, and all paid-in surpluses, as unavailable
sources for distribution.
Therefore, in contrast to Delaware which sets the outer limit on distributions on
the capital but not on paid in surpluses, the Israeli Companies Law sets aside, as
untouchable, the entire amount paid by the shareholders for their shares.
a.
Types Of Distributable Surpluses
U.S. legal literature normally cites four basic approaches to limiting corporate
distributions to shareholders in U.S. statutes.107 These four general approaches often
appear in combination.
Some states require that distributions be made out of surplus (the excess of net
assets over capital),108 and/or out of the earned surplus (the corporation’s accumulated
profits).109 Some states prohibit distribution, which could cause insolvency,110 and some
states have limitations based on current earnings.
U.S. legal commentators clearly draw a line between two central types of statutes:
“earned surplus” statutes and “capital surplus” or “surplus” statutes. Earned surplus
statutes differ from capital surplus statutes, in that earned surplus statutes disallow
106
Israel has followed the English Companies Law in defining the legal capital of the corporation.
See GROSS, supra note 40, at 341.
107
Peterson & Hawker, supra note 51, at 175,184; O’KELLEY & THOMPSON, supra note 7, at 57172; Richard O. Kummert, State Statutory Restrictions on Financial Distributions by Corporations to
Shareholders Part II, 59 WASH. L. REV. 185 (1984).
108
DEL. CODE ANN. tit. 8 § 154 (2001). Compare with The Companies Law, 1999 302(b) S.H.
189. Israel defines surplus more conservatively. The Companies Law, 1999 generally prohibits
distributions from unearned surpluses but leaves some unearned surpluses, as revaluation surpluses, in
question marks.
109
Id. The surplus test, which is applied in Delaware, is broader than the earned surplus test
applied in Israel and includes it.
110
See discussion infra p. 78.
34
distributions from paid-in surplus,111 from reduction surplus,112 and from revaluation
surplus.113 Earned surplus statutes are the closest to the approach reflected in the 1999
Companies Law (and its predecessors) with respect to public companies, particularly
when combined with the insolvency test, which is equivalent to Israeli common law
insolvency.
Under Delaware statute, distributions may be made out of any surplus, earned or
unearned,114 with the basic limitation that it shall not be paid out of capital. This test is
less stringent than the earned surplus test, and has earned the Delaware G.C.L. the title of
“impairment of capital” statute. In contrast, the Companies Law, which follows a more
conservative approach to distributions, clearly makes a distribution of unearned surpluses
unlawful.115
b.
The Earned Surplus
Earned surpluses, commonly known as retained earnings, are profits accumulated
by the corporation during its existence, less any dividends the corporation has paid out
since its inception. Both jurisdictions generally allow distributions from the earned
surplus account with much ease.116
111
Amounts paid in exchange for issued stocks, which exceed the par (stated) value of those
shares.
112
The amount by which stated capital can be reduced in some circumstances
The unrealized appreciation on fixed assets.
114
DEL. CODE ANN. tit. 8 § 170 (2001).
115
The Companies Law, 1999, 302 S.H. 189. The section also contains a provision allowing
nimble dividends (recognizing profit surpluses accumulated from the two years previous to the last
financial statement). See GROSS, supra note 40, at 342.
116
DEL. CODE ANN. tit. 8 § 170(1) (2001). See also DEL. CODE ANN. tit. 8 § 170 statutory notes
(2001) (earnings include current and accumulated earnings); The Companies Law, 1999, 302 S.H. 189.
113
35
Incidentally, the Companies Law’s principal test for distributions is the earned
surplus test.117 Under section 302 of the Act, distributions may be made out of the
corporation’s accumulated profits,118 providing that they do not result in the corporation’s
inability to pay its debts as they become due.119
Surplus is defined as net profits appearing in the capital account of the financial
statement,120 computed according to acceptable accounting methods,121 plus other
amounts that are included in the corporation’s capital account that are not share capital or
share premiums.122
In defining the surplus, the Companies Law sets out a two-part test. The first part
of the test looks at the past performance of the corporation. It is a historic test that does
not necessarily disclose information with regard to the future capabilities of the
corporation. The second part of the test looks at the future prospects of the corporation
and the likelihood it will be able to fulfill its obligations toward third parties.
Arguably, the second test presents some application difficulties. The test is
criticized as being subjective and unreliable. In comparison to the first test, which
117
The Companies Law, 1999, 302 S.H. 189. Section 302 also contains a nimble dividends
provision; GROSS, supra note 40, at 342.
118
The term “profits” was redefined in the new Companies Law to include nimble dividends.
Previously, the Companies Ordinance (Model Regulations, Supp. II) § 98 (1983) stated merely a general
rule that dividends must only be paid out of profits. This principle follows the English common law rule
stated in re Exchange, 21 ch. D. at 533). See application also in C.A. 5264/91 Valuation Officer for Large
Enterprises v. Ayit Imported Equipment Ltd., 49(3) P.D. 209, 216 (S. Ct. Isr.), C.A. 226/85 Sasa Securities
& Investments Co. Ltd. v. Adanim Mortgages & Loans Bank Ltd., 42(1) P.D. 14, 20 (S. Ct. Isr.).
119
The Companies Law, 1999, 302 S.H. 189.
120
Id.
121
The categorization of which surpluses are distributable is fundamentally linked to accounting
classifications. Such classifications determine which of the amounts that originate from the corporation’s
net profits should be prescribed to the capital account. The Companies Law reverts to “acceptable
accounting methods” in determining the net profits of a corporation. However, a definition of “net profits”
is lacking, and the Israeli CPA’s Bar has not yet resolved this issue. Nevertheless, the regulations governing
the preparation of financial statements provide, generally, that the net profit of a corporation include all
income and expenses from any source, be it on-going capital or other. See JACOB SAMET, FINANCIAL
ACCOUNTING (Vol. 1) 164-71 (1997); GROSS, supra note 40, at 342.
122
The Companies Law, 1999, 302 S.H. 189.
36
appears objective and more accurate, the future probability that a company will be able to
make payment on its debts is subject to estimates and requires careful attention.123
Generally, a distribution made in compliance with the requirements of the surplus
test is legitimate. However, if an Israeli corporation fails to satisfy the first prong, namely
that the distribution be made out of profits, it may still be able to distribute dividends,
with the authorization of the court, provided that it satisfies the second prong which is
being able to pay its debts as they become due.124
c.
Unearned Surplus
The Delaware (impairment of capital) model, does not distinguish between capital
surplus and earned surplus.125 The capital surplus test, being the less restrictive of the
two, can be said to incorporate the earned surplus test as well. Moreover, because the
capital surplus test focuses on the permanence of the stated capital, it essentially allows
distributions from sources that do not impair the stated capital, including distributions
from unearned surpluses.126
Unearned surpluses may occur in one of the following three ways: paid-insurplus, revaluation surplus, or reduction surplus.
1.
Paid-in-surplus
Paid-in-surplus may occur when the aggregate shareholder contribution exceeds
the stated capital represented by shares issued to shareholders. The paid-in-surplus is then
123
In the final draft of the 1999 Companies Law the legislator effectively rejected the application
of a third test, the liquidity test.
124
See GROSS, supra note 40, at 346.
125
DEL. CODE ANN. tit. 8 § 170 (2001); O’KELLEY & THOMPSON, supra note 7, at 572.
126
Recall that under section 170(a) of the Delaware G.C.L. corporations may pay dividends out of
surplus. DEL. CODE ANN. tit. 8 § 170(a) (2001). Surplus is the corporation’s net assets less stated capital. Id
§ 154.
37
the difference between the total paid in share capital and the stated capital represented by
the issued shares.
A Delaware corporation may pay out the entire surplus to its shareholders as
dividends.127 In contrast, Israeli law forbids the distribution of share capital, regardless of
its designation.128
2.
Revaluation surplus
Normally, the corporation’s assets, as shown on the balance sheet, reflect the
historical cost of each individual asset. Through revaluation, the corporation can write-up
the value of an asset to its currently higher market value.
Delaware courts and Israeli courts (with less conviction though) have
acknowledged that balance sheets are not conclusive indicators of surplus or a lack
thereof, and, therefore, allow corporations to revalue their assets.129
Delaware law generally allows corporations to revalue assets for the purpose of
creating a surplus from which the corporation could subsequently distribute dividends to
its shareholders. The directors of a Delaware corporation may further expect some
latitude from the courts to depart from the balance sheet in order to calculate surplus,
127
Compare, The Companies Law, 1999, 302(b) S.H. 189, DEL. CODE ANN. tit. 8 § 244 (2001).
The Companies Law, 1999, 302 S.H. 189. And see Han, supra note 48, at 318.
129
Klang v. Smith’s Food & Drug Ctrs., Inc., 702 A.2d 150, 152 (Del. 1997). And see id. at 154:
128
We understand that the books of a corporation do not necessarily reflect the
current values of its assets and liabilities. Among other factors, unrealized
appreciation or depreciation can render book numbers inaccurate. It is
unrealistic to hold that a corporation is bound by its balance sheets for
purposes of determining compliance with Section 160. Accordingly, we
adhere to the principles of Morris v. Standard Gas & Electric Co. allowing
corporations to revalue properly its assets and liabilities to show a surplus
and thus conform to the statute.
In Israel, the viability of revaluations as a source for distribution remains unclear. See BAHAT, supra note
47, at 443.
38
given that the evaluation is made “in good faith, on the basis of acceptable data, by
methods that they reasonably believe reflect present values, and arrive at a determination
of the surplus that is not so far off the mark as to constitute actual or constructive
fraud.”130
Israel’s position on this subject remains unclear. The legal community cautiously
supports revaluations as a necessary device, though, constantly echoing concerns
regarding the association of revaluations with distributions.131 In addition, Israeli courts
have not had the opportunity to resolve the uncertainty surrounding the viability of a
1961 English holding, stating that surpluses resulting from revaluation of fixed assets
may be distributed as a dividend or capitalized.132
Thus, whether unrealized profits resulting from a revaluation of fixed assets may
be so distributed or capitalized, remains undecided.133
The hesitance typifying Israeli lawmakers in embracing a broader application of
revaluations, reflects a concern that management might misuse this device.
For one thing, when increases in asset value result from short term market value
movements, creditors have much to be concerned about. The corporation will have
adjusted the value of the asset in its financial books, creating a surplus available for
distribution. Removing the surplus from the corporation, while the relevant asset is
susceptible to value decreases, could eventually impair the corporations capital.134
130
Klang, 702 A.2d at 152.
BAHAT, supra note 47, at 443. There are no concerns, however, with respect to events that do
not cause an export of assets.
132
Dimbula Valley (Ceylon) Tea Co. v. Laurie, [1961] Ch. 353, 370-374 [Eng.]
133
BAHAT, supra note 47, at 443 (questioning the viability of the rule stipulated in Dimbula).
134
Id.
131
39
Furthermore, directors generally enjoy enormous discretion in setting distribution
policies,135 and might manipulate the practice of asset revaluation to the detriment of the
creditors.136
American legal writers have been echoing similar concerns, and yet at least with
respect to Delaware, it appears that lawmakers felt confident they would be able to
minimize such misuse by other means.
3.
Reduction surplus
In addition to revaluation, Delaware, but not Israel, allows the reduction of stated
capital for the purpose of creating a surplus. This “artificial” surplus is then available for
distribution to the shareholders.
First, the directors of a Delaware corporation may decide, by resolution, to reduce
the corporation’s stated capital amount.137 By reducing the par value determinant in the
capital account, the directors can cause a somewhat artificial yet legal surplus.138 This
requires, of course, amending the articles of incorporation139 to which an action by the
135
The board of directors is under a duty to evaluate corporate assets on the basis of acceptable
data and by standards, which they are entitled to believe reasonably reflect present values. However, the
legislators of both Delaware and Israel found it impractical to lay down rigid rules as to what evidence
determines proper value, and so misuse of this device may go undetected. Furthermore, factors such as
future earnings and the prospects of stocks owned by the corporation may be considered in determining the
present value of an asset. This provides directors with additional latitude in ascertaining the current value of
corporate assets. See also Lawrence A. Cunningham, Commonalities and Prescriptions in the Vertical
Dimension of Global Corporate Governance, 84 CORNELL L. REV. 1133, 1181 (1999), and GROSS, supra
note 40, at 342.
136
See e.g., Klang, 702 A.2d at 153-156 (upholding management’s decision to revalue its balance
sheet, which made lawful a share repurchase that would have been unlawful without the revaluation under
the legal capital rules).
137
DEL. CODE ANN. tit. 8 § 242(a)(3) (2001).
138
See id. § 242(a)(3) (reducing capital), and id. § 244 (distributing/transferring/creating the
surplus).
139
If the corporation’s stock is no par to begin with, the stated capital can simply be reduced by a
board resolution that is approved by a majority of the stockholders. Where the corporation’s shares have
par value, then in order to reduce the par value, the corporation will have to amend the articles of
incorporation, which also will require shareholder approval.
40
shareholders is necessary. Shareholders’ approval is most likely, however, as the
expected benefit is the distribution of the surplus to themselves.
Consistent with Delaware’s G.C.L. section 170(a),140 the directors may declare
and pay dividends out of the corporation’s surplus. In the event that the corporation has
no surplus, the directors may still pay a dividend out of the corporation’s net profits.
However, since the corporation can ultimately decrease its authorized capital stock by
amending its certificate of incorporation,141 or reducing its capital (by reducing or
eliminating the capital represented by retired shares of capital stock),142 the directors can
effectively avoid the restrictions placed on distributions by indirectly increasing its
surplus.143
The ease with which stated capital could be reclassified as surplus, suggests that
legal capital presents no real obstacle to cash dividends.144 Under these circumstances,
stated capital can no longer be a secure source of guarantee for the creditors.
iii.
Nimble dividends
To the extent that Delaware sanctions the payment of dividends out of unearned
surplus as well as out of earned surplus, it operates a more liberal model than does Israel.
140
DEL. CODE ANN. tit. 8 § 170(a) (2001).
Id. § 242(a)(3) (“[The corporation] may amend its certificate of incorporation . . . [to] decrease
its authorized capital stock.”).
142
Id. § 244(a)(1) (providing a number of methods by which the board of directors may alter the
corporation’s capital structure). And see id. § 243 (stating that a corporation “may retire any shares of its
capital stock that are issued but are not outstanding.”), and (a corporation “may reduce its capital . . . by
reducing or eliminating the capital represented by shares of capital stock which have been retired.”) Id. §
244(a)(1).
143
F. John Stark, III et al., “Marriott Risk”: A New Model Covenant to Restrict Transfers of
Wealth From Bondholders to Stockholders, 1994 COLUM. BUS. L. REV. 503, 537 n.121 (1994).
144
Peterson & Hawker, supra note 51, at 199 n.114 (citing Richard O. Kummert, State Statutory
Restrictions on Financial Distributions by Corporations to Shareholders Part I, 59 WASH. L. REV. 185
(1984)) (“Even in cases where the surplus limitation appears to restrict a corporation’s ability to make a
distribution, surplus may be created by a change in accounting principles, by the recognition of unrealized
EWIS D.
appreciation in the value of the corporation' s assets, or by a reduction of stated capital.”); L
141
41
Recently, however, Israeli lawmakers have taken on a more lax approach to distribution,
by writing into the 1999 Companies Law a nimble (quick) dividend provision similar to
that of Delaware’s.145
Nowadays, Israeli corporations may make distributions from current net profits
(profits of the fiscal year in which the dividend is declared and/or the preceding fiscal
year), unless the distribution is expected to spin the corporation into a financial upset,
thus making it unable to pay its debts.146
In comparison, while Delaware’s G.C.L. contains no insolvency language for
distributions, a distribution may nevertheless be set aside as fraudulent.147
The Payment of nimble dividends is most useful when the corporation has
experienced losses for a number of years, followed by one or two years of earnings.
While the current earnings are not sufficient as to cerate a surplus, management may,
nevertheless, declare a dividend in order to signal to the shareholders and to the market
that the corporation has overcome its difficulties, thus increasing the firm’s attractiveness
without having to wait for a surplus, that would otherwise be required.148 The
aforementioned is illustrated in the following example.
SOLOMON ET AL., CORPORATIONS: LAW AND POLICY 260 (3d ed. 1994) (“Concepts of par value provided
little protection to creditors because of the ease with which restrictions could be circumvented.”).
145
The Companies Law, 1999, 302(b) S.H. 189; GROSS, supra note 40, at 343. And see also DEL.
CODE ANN. tit. 8 § 170(2) (2001) (providing that where the corporation experiences no surplus, it may still
distribute dividends out of its net profits for the fiscal year in which the dividend is declared and/or the
preceding fiscal year).
146
The legislator has extended the definition of profits to include current earnings. See The
Companies Law, 1999, 302(b) S.H. 189. Thus, the insolvency test that applies to general profits (section
302 of the Companies Law) applies with respect to current earnings as well. GROSS, supra note 40, at 343.
For the insolvency test see discussion infra p. 78.
147
David Mace Roberts & Rob Pivnick, Tale of the Corporate Tape: Delaware, Nevada, and
Texas, 52 BAYLOR L. REV. 45, 67-68 (2000).
148
The Companies Bill, explanatory notes § 348.
42
In 1998, corporation X issues 1,000 shares, each with a $10 par value, and sells
them for $10 each. Corporation X, therefore, has an initial stated capital in the amount of
$10,000, and has no capital surplus. In 1999 the directors of corporation X wish to
distribute a dividend to the shareholders, after a profitable year that has earned the
corporation $5,500. However, the corporation has no earned surplus due to accumulated
losses of $7,000, nor does the corporation have a capital surplus from which it could
lawfully distribute a dividend. Following is what corporation X’s balance sheet looks like:
Assets
Cash
Inventory
1,000
6,500
Liabilities and Shareholders’ Equity
Total Liabilities
Shareholders’ Equity
Stated Capital
Capital Surplus/ Paid-in Surplus
Earned Surplus/ Retained Earnings
7,500
1,000
10,000
(1,500)
7,500
In the absence of a surplus (earned or unearned), the directors of X corporation
have their “hands tied”. However, the nimble dividends provision enables the directors to
declare a dividend up to the amount earned in the previous fiscal year ($5,550) despite the
shortage of a surplus. Moreover, corporation X could further distribute dividends up to the
amount that the directors estimate the corporation will earn in the current fiscal year.
It is important to note that Delaware has given an expansive interpretation to its
nimble dividends provision, by authorizing directors to consider, when evaluating current
earnings, factors such as expected future earnings and prospects of stocks owned by the
corporation.149
149
DEL. CODE ANN. tit. 8 § 170 statutory notes (2001):
Factor such as future earnings and prospects and prospects of stocks owned
by corporation may be considered in determining present value under this
section and future prospects often constitute a most important factor where
43
For Israel, the nimble dividends provision presents yet another relaxation of the
previous tests applied under the Companies Ordinance of 1983. Israel’s nimble dividends
provision allows the board of directors to pay cash dividends even when the total
liabilities of the corporation exceed total assets.150 The provision presents a sharp move
away from the British approach on the subject, which generally prohibits distributions
where the corporation has accrued losses. 151
iv.
Distributions With The Consent Of The Court
One of the common arguments against the conservative approach to limit the
sources of distributions to profits, is that it overprotects creditors and unreasonably
restricts the corporation. Some critics propose that if the corporation’s assets exceed both
its debts and its distributions combined, then the corporation should be allowed to
proceed with a distribution without having other limitations imposed on it.152 And indeed,
in the final draft of the Companies Bill and in section 303(a) of the Companies Law, the
Israeli legislator recognizes the possibility that a corporation will carry out a distribution
that does not meet section 302’s two-part test for distribution.153
Section 303(a) of the Companies Law, provides, in pertinent part, that the court
may authorize distributions that do not meet the requirements of the standard test for
distribution, if the corporation can demonstrate to the court that there is no reasonable
present value is sought to be determined in ascertaining if a corporation may
declare dividends. Morris v. Standard Gas & Elec. Co. (citation omitted)
150
GROSS, supra note 40, at 343; MANNING & HANKS supra note 9, at 83.
See L.C.B. GOWER, GOWER’S PRINCIPLES OF MODERN COMPANY LAW 283 (London, 6th ed.
by P.L. Davies, 1997) and GROSS, supra note 40, at 343 (“No longer may ‘nimble dividends’ be paid out of
profits for the year, ignoring losses for previous years.”).
152
BAHAT, supra note 47, at p.455
153
I.e., that the distribution be made out of profits and will not impair the corporation ability to
pay its debts.
151
44
concern that the distribution may result in its inability to carry out its present and
foreseeable obligations as they become due.
The creditors of a corporation who are seeking the approval of the court, have the
opportunity to present their arguments and objections to the distribution.154
154
The Companies Law, 1999, 303(c) S.H. 189.
45
CHAPTER 4
CRITICISM OVER TRADITIONAL LEGAL CAPITAL DOCTRINES
Legal capital restrictions, which were based on par value notions, were nearly a
universal feature of general corporation codes in the U.S. until 1980.155 In 1980, the
Committee on Corporate Law of the American Bar Association recognized that legal
capital rules were technical and arcane, and completely deleted the financial provisions in
the Model Business Corporation Act.156
Similar criticism has been echoing in Israel’s legal literature for over a decade, yet
it has instigated little change. Within the U.S., Delaware remains among the minority of
states that continues to apply legal capital rules in its corporation codes.
Legal scholars from both Israel and Delaware have long criticized the legal capital
doctrines for failing to achieve their primary objective of protecting the creditors.157 With
the introduction of nominal or no-par value stocks, stated capital no longer represented
the collective contributions of the initial shareholders on which creditors arguably relied.
155
O’KELLEY & THOMPSON, supra note 7, at 568.
Committee on Corporate Laws, Changes in the Model Business Corporation Act -Amendments to Financial Provisions, reprinted in 34 BUS. LAW. 1867 (1979).
157
Id. at 1867 (“It has long been recognized . . . that the pervasive structure in which ‘par value’
and ‘stated capital’ are basic to the state corporation statutes does not today serve the original purpose of
protecting creditors and senior security holders from payments to junior security holders.”); MANNING &
HANKS supra note 9, at 91 (“[T]he statutory legal capital machinery provides little or no significant
protection to creditors of corporations.”); Peterson & Hawker, supra note 51, at 198 n.111, citing Robert C.
Art, Corporate Shares and Distributions in a System Beyond Par: Financial Provisions of Oregon’s New
Corporation Act, 24 WILLIAMETTE L. REV. 203, 205 (1988) (“The original goals of the traditional legal
capital system . . . were laudable: the protection of investors and creditors.”); William H. Ralston, Note,
The 1980 Amendments to the Financial Provisions of the Model Business Corporation Act: A Positive
Alternative to the New York Statutory Reform, 47 ALB. L. REV. 1019, 1025 (1983) (“The intention behind
the traditional statutory scheme . . . is to provide a cushion for the protection of creditors.”); BAHAT, supra
note 47, at 456; Ephraim Shmidler & Dan Sheinfeld, Dinei Shmirat Hahon Behatza’at Hok Hahavarot –
156
45
46
Par value itself became an arbitrary number susceptible to changes, which did not
represent the amount of cash or the value of other assets in the corporation.158
Furthermore, critics maintain that creditors have better means to protect their interests,
from credit reports to the bankruptcy code and bond covenants.159
Clearly, legal capital does not provide, nowadays, any real information with
regard to the ongoing economic condition of the enterprise.160 The corporation’s legal
capital, which has become a mere legal construct, may be much smaller than the
economic capital generated by the issue of stock. As a result, statutory legal capital
schemes provide no significant protection to creditors.
Nevertheless, do creditors really require the “safeguards” of the legal capital
rules? The legal capital rules never prevented the erosion of corporate cash flow, nor did
they prevent the incurrence of additional, possibly secured or senior, corporate debt.161 In
“Clalim Optimalim”? [The Rules of Capital Preservation in the Companies Bill – “Optimal Rules”?],
A(3) SHA’AREI MISHPAT 323 (June 1998) (Isr.).
158
Manning and Hanks described the legal capital doctrine as having,
[L]ittle or no relationship to the word ‘capital’ as the economist, or even the
businessman, knows it. Nor is it the block of assets that Justice Story had in
mind…Legal capital is entirely a legal invention, highly particular in its
meaning, historical in reference, and not relatable in any way to the ongoing
economic condition of the enterprise. For most purposes it is best thought of
simply as a dollar number-a number having certain consequences and derived
by specified statutory procedures, but just a number. MANNING & HANKS,
supra note 9, at 39
159
Creditors generally use guarantees, secured loans, and stringent default provisions to protect
their interests. See Peterson & Hawker, supra note 51, at 199.
160
It is argued that the historical relationship between the value of the corporation and its stated
capital has been severed once the stated capital became an abstract number obtained by multiplying the
number of shares outstanding by the par value assigned to each share. See Eisenberg, supra note 60, at 199:
[L]egal capital was conventionally more or less equal to the economic capital
created by the issue of stock. Modern statutes, however, do not require that
shares have a par value, and even shares that have a par value may carry a par
value much lower than the price at which they are issued.
161
MANNING & HANKS, supra note 9, at 91.
47
fact, it is often suggested that creditors focus not on the sufficiency of assets remaining
upon liquidation of the corporation, but rather, “on the corporation’s prospects for
remaining a viable on-going concern.”162
We need to critically consider what the payoffs of this model are, and the extent
to which they validate the strain placed on corporate planning and growth.
162
Ralston, supra note 157, at 1027, cited in Peterson & Hawker, supra note 51, at 200.
48
CHAPTER 5
THE MOTIVES FOR ENGAGING IN CASH DISTRIBUTIONS
AND SHARE REPURCHASES
I.
Introduction
Investors and financial analysts often perceive public corporations that engage in
the payment of generous dividends, as attractive investments.
For one thing, some regard a dividend payment policy as an indicator of the
firm’s prospective, as professed by corporate insiders.163 A growth or a cut in the
dividend may be looked upon as signals concerning the financial soundness of the firm,
the assumption being, that with no corresponding increases in real earning power, firms
are much less likely to be able to increase their dividends over a long period of time.164
In addition, corporations that adopt a dividend policy, in effect share-out assets
throughout the life of the investment. Many investors prefer receiving a regular stream
of cash on their investments without having to wait years for capital appreciation. There
is a clear incentive in investing in a dividend paying corporations, especially where
there is uncertainty with regard to the firm’s ability to increase its earnings. The
distribution of wealth back to the investors generally reduces some investment
risks.165Dividend distributions may reduce risks associated with value decreasing
163
See GROSS, supra note 40, at p. 346; YIZHAK SUARI ET AL., HEBETIM BAHALUKAT DIVIDEND
[OBSERVATIONS ON DIVIDEND DISTRIBUTIONS] 27-29 (1999); Joseph Williams, Efficient Signaling with
Dividends, Investment, and Stock Repurchases, 43 J. FIN. 737 (1988).
164
Id.
165
GROSS, supra note 40, at p.349.
48
49
investments made by the corporation, and the risk that management will appropriate
corporate assets.
Finally, there is an obvious advantage in such regular cash payments, the
alternative being periodically selling portions of holdings which attract transaction costs
(brokerage commissions).
The payment of a large special dividend may also be used as a tactical measure to
fend-off hostile bidders,166 by offering equal or greater value, or preempting a likely
hostile takeover.167 In doing so, the corporation could borrow money and use it to pay a
large special dividend to its shareholders. After the dividend, the firm will be highly
leveraged.
In addition to dividend distributions, there are other methods of distributing cash
to the public shareholders, including share repurchases from shareholders. Share
repurchases, or buybacks, are, “distributions of cash by a firm in exchange for a portion
of its outstanding common stock.”168
Buybacks are financial devices which have similar purposes as stock issuances,
but opposite effects. A corporation requiring additional capital may respond by issuing
stock. Buybacks are like reverse stock issuances in the sense that when the corporation
experiences a surplus cash flow, or has earnings which exceed those needed to finance
positive net present value investment opportunities,169 it may announce a buyback.170
166
GILSON & BLACK, supra note 24, at 402.
The term “takeover” describes the acquisition of control of a business enterprise. See The
Dictionary of Financial Risk Management, available at http://riskinstitute.ch/
168
See F.H. Buckley, When the Medium Is the Message: Corporate Buybacks as Signals, 65 IND.
L.J. 493 (1990).
169
GILSON & BLACK, supra note 24.
170
Buckley, supra note 168, at 494.
167
50
Generally, a corporation can repurchase its own shares either through an open
market repurchase, a tender offer repurchase, or a private repurchase.171 Although it is
reported that most of the cash distributed by public corporations to their shareholders still
takes the form of dividends, an increasingly large proportion of this cash is distributed by
repurchasing shares from public shareholders.172
Common explanations for the growing popularity of share repurchases relate to
their tax efficiencies over the tax treatment of dividends,173 and their effect on
171
Jesse M. Fried, Insider Signaling and Insider Trading with Repurchase Tender Offers, 67 U.
CHI. L. REV. 421, 421 (2000) (hereinafter Fried, Insider Signaling) (in tender offer repurchases a
corporation will offer to buy back its own stock, usually at a premium over the market price); Buckley,
supra note 168, at 494-95 (on types of repurchases):
Self-tenders must be made in accordance with regulations similar to those
governing ordinary tender offers, including the solicitation of “all
shareholders,” with proration if an offer is oversubscribed. Open market and
private repurchases are not subject to these regulations, because they may be
structured so as not to constitute “tender offers” under the Williams Act.
Open market repurchases are made on secondary markets at the thenprevailing price, while private or “targeted” repurchases are made from a few
sellers at a price which usually exceeds market value.
172
Fried, Insider Signaling, supra note 171, at 427.
Share repurchases are generally more tax efficient than dividends for the following reasons.
First, the funds allotted to dividend payments will effectively be taxed twice where the recipient is an
individual. The corporation will pay income tax and the recipient individual will then pay federal taxes on
the dividend. Furthermore, the recipient will have to incur reinvestment costs instead of having had the
corporation invest the funds internally from the outset. While dividends are taxable for many taxpayers,
cash, paid in a stock repurchase, is not taxed to the extent that it represents a return of the initial investment
(basis). See Fried, Insider Signaling, supra note 171, at 427 n.26. However, it is important to note that
many dividend recipients are either not taxed at all, or are lightly taxed. For example, pension funds, which
hold a significant portion of corporate stock, are completely tax-exempt. Similarly, inter-company
dividends are only lightly taxed in the owner’s hands. Thus, X corporation, which owns stock in Y
corporation, would be subject to higher capital gain tax if X was to sell off its stock-holdings in Y, after Y
has reinvested all of its dividends and experienced as a result an increases in stock value. For share
repurchases to avoid the tax implications that dividends experience (and be considered superior) they must
not be essentially equivalent to a dividend. That is, they cannot be pro rata. See 26 U.S.C. § 302(b) (2001)
(“Redemptions treated as exchanges. (1) Redemptions not equivalent to dividends. Subsection (a) shall
apply if the redemption is not essentially equivalent to a dividend. (2) Substantially disproportionate
redemption of stock.”). Thus, any payment in excess of the basis (amount representing the initial
investment in that stock) will be taxed as capital gain. In many cases the tax rates on capital gain will be
lower than the ordinary tax rate imposed on dividends. See Fried, Insider Signaling, supra note 171, at 427
n.26.
173
51
management stock options.174 There are, however, additional theories why a corporation
may wish to repurchase its common stock. For one, the corporation may have excess cash
that it cannot productively reinvest in its own business. It is suggested that under such
circumstances, returning this cash to the shareholders by repurchasing their shares is
more sensible.175 Other financial strategies may include objectives such as raising
earnings per share, rewarding non-selling shareholders of undervalued stock, and
manipulating stock value.
It is widely argued that increasing the firm’s leverage will consequently reduce
agency costs, by improving managerial incentives.176 Borrowing funds for the purpose of
carrying out a stock repurchase program, or paying a special dividend, may help in
reducing agency costs. At the same time, it must be noted that increasing the firm’s
leverage is synonymous with transferring value from creditors.177
174
See Fried, Insider Signaling, supra note 171, at 427 n.27 for the premise that tax repurchases
are less likely (than dividends) to downgrade the value of managers’ stock options:
Cash dividends reduce the per-share value of the firm, which in turn lowers
the market price of the stock. The value of stock options depends on the
difference between the exercise price (the price at which the manager may
purchase the stock) and the market price (the price at which the manager may
sell the purchased stock). Thus, unless the options’ exercise price is lowered
to take dividends into account, the effect of dividends will be to reduce the
options’ value. Repurchases do not reduce the per-share value of the firm
(and hence the stock price) to the extent the outflow of value is matched by a
corresponding reduction in the number of outstanding shares.
Although share repurchases may be more tax efficient than dividends and have less of an adverse
impact on the value of managers’ stock options, there are countervailing considerations that may make
dividends a more attractive mechanism for distributing cash in some cases. Other considerations may make
dividends a more attractive means for distributing cash in some cases. Dividends are a less expensive
method for corporations to distribute cash when the stock is overvalued. See id. at 427 n.28, and Bhagwan
Chowdhry & Vikram Nanda, Repurchase Premia as a Reason for Dividends: A Dynamic Model of
Corporate Payout Policies, 7 REV. FIN. STUD. 321 (1994). Dividends may reduce the risk of shareholder
expropriation by insiders. See GILSON & BLACK, supra note 24.
175
On the excess cash (free cash) theory see Fried, Insider Signaling, supra note 171, at 438.
176
On the agency cost theory see, generally, Fried, Insider Signaling, supra note 171, at 439-40.
See also text infra p. 53.
177
On the creditor expropriation theory see Fried, Insider Signaling, supra note 171, at 440.
52
Stock repurchase programs, as special dividend programs, are also a most popular
device for defeating an unwanted takeover bid,178 or simply as a means of reducing the
issuer’s vulnerability to unsolicited acquisitions.179
Finally, a corporation may decide to repurchase (or redeem) its own shares for
general business reasons, including reducing aggregate dividends and other shareholder
servicing costs, satisfying stock options without diluting earnings per share, fulfilling
buy-sell agreements on the death of a shareholder, or eliminating fractional shares.180
II.
Leveraged Recapitalizations
Corporations undergoing leveraged recapitalization, will sometimes borrow funds
and use them to either pay a large special dividend to the shareholders, or to repurchase a
large fraction of their outstanding shares.181 As a result, such corporations will have
increased their leverage level, and will now be obligated to repay the cost of their new
debt. Their capital structure will remain unchanged where they undergo recapitalization
followed by a dividend payout, whereas if the funds are used to repurchase shares, then
their remaining equity will be divided into fewer outstanding shares.
Gilson and Black report that most leveraged recapitalizations are defensive, and
are entered into as a way to defeat a hostile takeover bid.182 In essence, leveraging a
corporation through restructuring, reduces the firm’s attractiveness to a hostile bidder by
depleting corporate assets. The leverage proceeds leave the corporation to the hands of its
178
On stock repurchase as a defensive measure see GILSON & BLACK, supra note 24, at 761.
On stock repurchase as a preventive measure see id.
180
Allen Resnick, The Deductibility Of Stock Redemption Expenses And The Corporate Survival
Doctrine, 58 S. CAL. L. REV. 895, 895 n.2 (1985).
181
Often management will use the dividend money to purchase more stock in order to increase
management’s ownership percentage.
182
GILSON & BLACK, supra note 24, at 402.
179
53
shareholders, increasing the short-term value of their investments while decreasing the
value of the corporation itself.
Nonetheless, the benefits of recapitalization have been recognized, apart from
solely being a defensive tactic. The agency cost theory, proposes that repurchases and
special dividend distributions might reduce agency costs by improving managerial
incentives.
First, where the repurchase or dividend distribution is funded with new debt, the
obligation to make (additional) recurring interest payments may encourage managers to
focus on performance and revenues, cutting costs and increasing efficiency.183
Second, to the extent that buybacks increase management’s proportional
ownership of the corporation (by reducing the number of shares outstanding), the
repurchase may serve as a performance incentive, encouraging management to take only
value increasing actions as they will share a better fraction of the value they create.
Otherwise, management can be expected, unless constrained, to maximize their own
welfare rather than the shareholders’.184
183
Buckley, supra note 168, at 520-22 (once new debt is issued, the new creditors might be better
suited for monitoring managers than the existing shareholders); Fried, Insider Signaling, supra note 171, at
439; Michael C. Jensen, The Takeover Controversy: Analysis and Evidence, in Knights, Raiders & Targets:
The Impact of the Hostile Takeover, 321-22 (John Coffee et al. eds., 1988) (applying the free cash flow
theory to mergers, Jensen identifies a similar effect. Jensen theorizes that managers have incentives to
retain free cash flow rather than distributing it to shareholders, and to use the free cash flow to make
negative net present value investments).
184
See Michael Jensen & William Meckling, Theory of the Firm: Managerial Behavior, Agency
Costs and Ownership Structure, 3 J. FIN. ECON. 305 (1976) (while management acts as agents of the
shareholders and should, presumably, act in the shareholders’ best interest, it can be expected to promote its
own inertest in the absence of effective monitoring. Thus, it is in the owners’ interest to incur monitoring
costs. It will also be in the owners’ interest to provide profit-sharing incentives to reduce the divergence of
interest between management and the shareholders).
54
Gilson and Black describe the ideal candidate for a leveraged recapitalization as a
mature, slowly growing, company, having predictable cash flows and generating more
cash than it can profitably reinvest in its business.185
Michael Jensen, and other writers, maintain that in cash-rich, low growth or
declining sectors, the pressure on management to waste cash flow internally and make
investments in unsound projects, is often irresistible.186 Jensen stresses the importance of
leverage as an instrument in reducing the agency costs associated with free cash flow.187
The benefits of such capital structure transformation exceed, in Jensen’s view, the
traditionally recognized benefits of a publicly held corporation (diversifying and
customizing risks with diversified portfolios of public investors that would otherwise be
borne by the owners, and facilitating the creation of a liquid market for exchanging risk,
i.e., causing a decrease in the cost of capital).188 Jensen concludes that, “[t]he genius of
the new organizations is that they eliminate much of the loss created by the conflicts
between owners and managers, without eliminating the vital functions of risk
diversification and liquidity once performed exclusively by the public equity markets.”189
Michael Jensen suggests, replacing the public corporation structure (funded by
public equity) with public and private debt structure as a major source of capital, where
the corporation’s long-term growth is slow, where internally generated funds exceed the
opportunities to invest in them profitably, or where downsizing is the most productive
185
GILSON & BLACK, supra note 24, at 403 (as opposed to a fast growing company which is
unsuitable because it needs all the available cash it has to reinvest in its business).
186
Michael C. Jensen, Eclipse of the Public Corporation, 67 HARV. BUS. REV. 61 (Sept.-Oct.
1989) (hereinafter Jensen, Eclipse of the Public Corporation).
187
Jensen maintains that a decline of publicly held, equity funded corporations, and the increase of
closely held, debt-funded corporations may reduce the agency costs associated with free cash flow. See id.
188
See Jensen, Eclipse of the Public Corporation, supra note 186, reprinted in GILSON & BLACK,
supra note 24, at 407.
189
See id.
55
long-term strategy.190 Jensen claims that the survival of the public corporation may
depend on its ability to centralize ownership control, using leverage to avoid the
consequences of the conflict of interest between those who bear the risk (shareholders
and creditors) and those who manage it (executives).191
Jensen treats debt as a mechanism superior to discretionary dividends in its ability
to force management to pay out future cash flows rather than spend it on, “empirebuilding projects with low or negative returns, bloated staffs, indulgent perquisites, and
organizational inefficiencies.”192 Due to intensified monitoring which follows an increase
in leverage, management has an incentive to perform well and avoid wasting assets,
because they are more vulnerable to displacement.
Finally, aside from borrowing funds for the purpose of distributing dividends, and
repurchasing shares for the purpose of reducing the waste of free cash flow, Jensen
recognizes the benefits of having a highly leveraged firm at the stage of insolvency or
near insolvency. Jensen argues that the costs of becoming insolvent are likely to be
significantly smaller where the firm is highly leveraged. He further argues that highly
190
See id. (Jensen’s debt finance versus stock finance hypothesis incorporates theories on the role
of debt in reducing managerial agency costs and the conflicts of interest between managers and
shareholders, and bondholders and shareholders).
191
For criticism over Jensen’s approach see Alfred Rappaport, The Staying Power of the Public
Corporation, 68 HARV. BUS. REV. 96 (Jan.-Feb. 1990) (leveraged buyouts are inherently transitory; high
debt levels and concentrated ownership impose costs in the form of reduced managerial flexibility in
responding to competition and change); Steven N. Kaplan, The Staying Power of Leveraged Buyouts, 29 J.
FIN. ECON. 287, 290 (1991) (leveraged buyouts are not permanent, but are not short-lived); Norm Alster,
One Man’s Poison .... (Who Benefits from Leveraged Buyouts), FORBES, Oct. 16, 1989), discussed in
Kimberly D. Krawiec, Derivatives, Corporate Hedging, and Shareholder Wealth: Modigliani-Miller Forty
Years Later, 1998 U. ILL. L. REV. 1039 (high debt makes firms less flexible. This can lead to long-run costs
where leveraged firms are unable to compete and expand as aggressively as their non-leveraged rivals. The
result, major market share).
192
Jensen, Eclipse of the Public Corporation, supra note 186, reprinted in GILSON & BLACK,
supra note 24, at 407.
56
leveraged firms rarely enter formal bankruptcy, because they are reorganized quickly at
lower costs.193
III.
The Excess Cash Theory
The excess cash theory is a leading explanation for non-defensive repurchases.194
According to the excess cash theory, corporate insiders have a propensity to plow-back
too much of the cash generated by their firms because they have an inclination to spend it
on power building, prestige, and compensation, the last two of which normally increase
with the size of the firm.195 By repurchasing shares or distributing dividends, the firm
returns these unneeded funds to the shareholders, and management’s ability to waste free
cash in this manner is reduced.196
IV.
The Signaling Explanation
While many accounting and legal scholars advocate that dividend distributions
and stock repurchases are, essentially, cosmetic maneuvers that hardly reflect income
concentration or balance sheet valuation, more than sixty years of studies reveal that
shareholders generally react positively to stock distribution announcements.197
193
See id. at 413-14.
See Rene M. Stulz, Managerial Discretion and Optimal Financing Policies, 26 J. FIN. ECON. 3
(1990) (use of debt to reduce free cash flow and managerial agency costs); Tom Nohel & Vefa Tarhan,
Share Repurchases and Firm Performance: New Evidence on the Agency Costs of Free Cash Flow, 49 J.
FIN. ECON. 187 (1998). But see Keith M. Howe et al., One-Time Cash Flow Announcements and Free
Cash-Flow Theory: Share Repurchases and Special Dividends, 47 J. FIN. 1963, 1965 (1992) (finding no
empirical support for free cash flow benefits of share repurchasing). Compare, Steven B. Perfect et al., SelfTender Offers: The Effects of Free Cash Flow, Cash Flow Signaling, and the Measurement of Tobin’s q, 19
J. BANKING & FIN. 1005, 1006-07 (1995) (criticizing Howe and finding some empirical support for the free
cash flow benefits using a different approach).
195
Michael C. Jensen, Agency Costs of Free Cash Flow, Corporation Finance, and Takeovers, 76
AM. ECON. REV. 323 (1986).
196
Fried, Insider Signaling, supra note 171, at 438.
197
Peterson & Hawker, supra note 51, at 207; Eugene F. Fama, Lawrence Fisher et al., The
Adjustment of Stock Prices to New Information, 10 INT' LECON. REV. 1, 16 (1969) (empirical evidence
suggests that shareholders interpret distributions, stock dividends and stock splits as information about the
financial disposition and prospects of the firm.); C. Austin Barker, Evaluation of Stock Dividends, HARV.
BUS. REV. (July. 1958), cited in Peterson & Hawker, supra note 51, at 206 n.160.
194
57
Managers often have inside information198 that is not reflected in the stock
price.199 This information may indicate that the stock is under priced or overpriced. In
order to disclose this information to shareholders, management may wish to communicate
it to shareholders through a general announcement as a dividend distribution or stock
repurchase. The suggested theory is that managers may use dividend distributions or
share repurchases to convey information about the firm value.200 Through stock
distribution announcements, management will either look to signal the permanence of
past earnings or the increased potential of future earnings.201 Indeed, current studies offer
signaling explanations for observed price responses to such announcements.202
According to the signaling theory, for a signal that the stocks are under priced to
be credible, managers must act in a way that will impose substantial costs on them if the
stock is not actually under priced.203 A tender offer repurchase204 facilitates the sending
of such a credible signal, particularly when offering to repurchase shares at a premium
198
“Inside information” is nonpublic information available to insiders by virtue of their positions
within the corporation, including information relating to the value of the firm. See Buckley, supra note 168,
at 528, 536-37 (1990) (the nature and relevance of “soft” information).
199
See id. at 528, 536 (insiders have better information than public shareholders); Jesse M. Fried,
Reducing the Profitability of Corporate Insider Trading Through Pretrading Disclosure, 71 S. CAL. L.
REV. 303, 317-29 (1998) (insiders have inside information not reflected in the stock price).
200
Shmidler & Sheinfeld, supra note 157, at 326.
201
Maureen McNichols & Ajay Dravid, Stock Dividends, Stock Splits, and Signaling, 45 J. FIN.
857, 871 (1990) (managers incorporate private information about future earnings in setting the split factor
in a stock split); Paul Asquith et al., Earnings and Stock Splits, 64 ACCT. REV. 387 (1989).
202
Studies supporting a signaling theory as an explanation for investor reaction to stock
distribution announcement include Fischel, The Law and Economics of Dividend Policy, 67 VA. L. REV.
699, 708-09 (1981) (hereinafter Fischel, Dividend Policy) (changes in dividend policy can send signals to
investors about the firm’s prospects, thereby affecting share prices); Michael J. Brennan & Patricia J.
Hughes, Stock Prices and the Supply of Information, 46 J. FIN. 1665 (1991); McNichols & Dravid, supra
note 201; Fried, Insider Signaling, supra note 171; Stephen A. Ross, The Determination of Financial
Structure: The Incentive Signaling Approach, 8 BELL J. ECON. 23 (1977); Sudipto Bhattacharya,
Imperfect Information, Dividend Policy and 'The Bird in the Hand’ Fallacy, 10 BELL J. ECON. 259
(1979).
203
Fried, Insider Signaling, supra note 171, at 442.
204
In a tender offer the corporation makes a time-limited offer to repurchase a specified amount of
stock.
58
over the market price.205 By committing not to tender their shares, insiders can credibly
signal that the stock value is higher than the repurchase price.206
The signaling theory can also explain why managers might prefer buying back
stocks over distributing dividends. A dividend does not confer information over insiders’
beliefs as effectively and precisely as a tender offer repurchase, because it does not
compel insiders to purchase shares at a particular price.207 However, while dividend
distributions do not signal much information about the value of the stock relative to the
market price, a dividend policy may be interpreted by investors as managers’ forecasts of
future earnings changes.208
There is some question about why and to what extent dividend policy affects
security prices. The signaling power of insiders may explain the differing market
reactions to the announcement of dividend initiations.209 The pure model of the efficient
market hypothesis210 posits that in a world of perfect information, dividend policy should
205
For the advantages of tender offers over open market repurchases see Fried, Insider Signaling,
supra note 171, at 443:
The signaling theory can explain why a firm would conduct an RTO
[repurchase tender offer] rather than an OMR [open market repurchase]. In
particular, an OMR does not send as precise a signal as an RTO . . . . An
RTO enables insiders to better demonstrate the extent to which the stock is
under priced by allowing them to set the offer price equal or closer to its
actual value.
206
Id. at 442. See also id. at 443 (the larger the repurchase amount and the higher the percentage
of insider ownership the more credible is the signal.).
207
See id. at 443.
208
Paul M. Healy & Krishna G. Palepu, Earnings Information Conveyed by Dividend Initiations
and Omissions, 21 J FIN. ECON. 149 (1988); Merton H. Miller & Kevin Rock, Dividend Policy Under
Asymmetric Information, 40 J. FIN 1031 (1985).
209
Benjamin Graham discusses the historical primacy of dividends in investment decisions
through the dividend theory of stock valuation. The theory posits that dividend policy is the single largest
determinant of share value. See BENJAMIN GRAHAM ET AL., SECURITY ANALYSIS: PRINCIPLES AND
TECHNIQUES, 480-82 (4th ed. 1962).
210
On the efficient market hypothesis see generally O’KELLEY & THOMPSON, supra note 7, at
169-74.
59
have no effect on the value of a firm or the market value of its stock.211 However, in the
real world, where information regarding stock value is disseminated to the general public
asymmetrically, dividends may serve as a signaling function.212
Generally, dividend initiations or increases are interpreted as mirroring expected
earnings increases and firm value.213 Therefore, unexpected increases or decreases in
dividend policy are thought to affect stock prices. Furthermore, analysts commonly tie
the effects of dividend policy to the availability, or lack thereof, of positive net present
value investment opportunities within the firm.214
It is further argued that dividends are a superior signaling source because, unlike
other forms of information about a firm’s prospects, changes in dividend policy are more
reliable. The case made is that while financial accounting and projections of management
are subject to a good deal of manipulation and bias, dividend changes require a company
“to put its money where its mouth is.”215
211
See Merton H. Miller & Franco Modigliani, Dividend Policy, Growth and the Valuation of
Shares, 34 J. BUS. 411 (1961) (discussing the effects of a firm’s dividend policy on the current price of its
shares).
212
See Bhattacharya, supra note 202 (cash dividends function as signal of expected cash flows);
Miller & Rock, supra note 208.
213
But see W. KLEIN & J. COFFEE, BUSINESS ORGANIZATION AND FINANCE 303-06 (2d ed. 1986)
(makes the case that the total value of a firm is determined by investment policy, not dividend policy);
Fischel, Dividend Policy, supra note 202, at 701 (“Because a firm’s dividend policy . . . is simply a
decision as to how the firm’s real value should be packaged for distribution, it should have no effect on
share prices.”); Victor A. Brudney, Dividends, Discretion, and Disclosure, 66 VA. L. REV. 85, 86-87
(1980) (suggests that dividend policy is merely the residual of investment policy and, as such, irrelevant to
share prices).
214
See Kose John & Larry H. P. Lang, Insider Trading Around Dividend Announcements: Theory
and Evidence, 46 J. FIN. 1361, 1367 (1991) (increased dividends may convey negative information).
Although market professionals generally agree that dividends are important to shareholders, others defend
Professors Miller and Modigliani’s irrelevance theory. Miller and Modigliani argue that if a company can
reinvest free cash at a return equal to the firm’s current return, then the shareholders should be indifferent
to whether the company pays a dividend or reinvests the available cash. See Merton Miller & Franco
Modigliani, Dividend Policy, Growth, and the Valuation of Shares, 34 J. BUS. 411 (1961). For further
discussion on the irrelevance theory see Richard A. Booth, Discounts and Other Mysteries of Corporate
Finance, 79 CALIF. L. REV. 1055, 1064 n.25 (1992).
215
Booth, supra note 214, at 1067. And see id. at 1067 (any company can claim financial health,
but a company that is really doing better ought to be able to extract more cash and pay it out). And see also
60
In much the same way, a reduction in dividends, namely a failure to maintain the
payout rate, is a negative signal that the company is facing financial difficulties. This
could explain why corporate boards are generally reluctant to adjusted dividends
downward due to the potentially negative impact on the company’s stock price.216
However, because the market does not react favorably to dividend cuts, the corporate
board will typically try to avoid them and, at times, contrary to all financial sense.
A repurchase program performs a function similar to that performed by the
payment of dividends, though interferes less with the parties’ investment preferences.
The corporation can fine-tune its policy, buying at one time and not at another, whereas
with a dividend policy, the corporation is almost locked into a periodically increasing or
at least constant amount.
i.
Undervalued Stock
Corporate managers often engage in stock repurchases when the market
temporarily undervalues the corporation’s stock.217 Non-selling shareholders are
inevitably rewarded, as they will get a better piece of the undervalued pie at no additional
cash outlay.
Often, corporations launch stock repurchase programs with the announced
intention of increasing the price of their equity securities. Such repurchases are premised
on the belief that a reduction in the supply of outstanding stock will lead to price
increases of the remaining (non tendering) shares. A growing number of scholars have
id. at 1075 (“Shareholders are inconvenienced by irregular cash flows and corporate managers can without
great difficulty adjust their cash resources so as to pay steady dividends. Thus, dividends should be not only
generous but stable.”).
216
Norris, Market Place: On Dividends, Some Fresh Hope, WALL ST. J., Jul. 2, 1991, at D8, col.
2, cited in Booth, supra note 214, at 1067 n.33.
217
Shmidler & Sheinfeld, supra note 157, at 326; BAHAT, supra note 47, at 352.
61
studied this phenomenon over the years, and contrary to traditional notions,218 have
presented the view that stock prices are much like other commodities in that their price is
sensitive to varying levels of supply and demand.219
ii.
Raising Earnings Per Share
Another rationale in support of share repurchasing is that it may instigate a rise in
the earnings per share.220 Earnings per share are probably the most important single
determinant of share prices.221 A buyer of common stock is often more concerned with
the earnings power of a stock than with its dividend. This is because earnings per share
usually influence the stock market prices. When the earnings per share ratio rises, share
value is likely to improve as well, depending on how cheap the stock is, relative to its
earning power.
Scholars suggest that the stock market uses earnings as signals to make a rational
forecast of firm value.222 Since higher earnings today are likely to be correlated with
218
That the shareholder supply curve for publicly traded stock is flat.
Empirical studies have made it increasingly clear that the shareholder supply curve for publicly
traded stock is not flat, but rather upward sloping. That is, in order to purchase more shares, one must pay a
higher price because shareholders have different reservation values for the same stock. The market price
therefore reflects the value of the lowest-valuing or marginal shareholder and “[s]hareholders with higher
reservation values are not willing to sell at the market price. Those with lower reservation values will
already have sold their shares.” Fried, Insider Signaling, supra note 171, at 435; Richard A. Booth, The
Efficient Market Portfolio Theory and the Downward Sloping Demand Hypothesis, 68 N.Y.U. L. REV.
1187, 1188 n.3 (1993); Anise C. Wallace, Takeovers and Buybacks Propping Up Stock Prices, N.Y. TIMES,
June 20, 1988, at D1 (studying stock repurchases and their effects on share prices); Laurie Simon Bagwell,
Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity, 47 J. FIN. 7, 97 (1992); Larry Y.
Dann, Common Stock Repurchases: An Analysis of Returns to Bondholders and Stockholders, 9 J. FIN.
ECON. 113, 136-37 (1981) (self-tender offers tend to involve larger amounts and seem motivated by low
stock prices. Stock repurchases tend to increase share prices).
220
Earnings per share (EPS) represent the share of the earnings that each stock is entitled to (net
income divided by common shares outstanding). EPS are an important indicator in assessing stock value.
221
For instance, the most widely used indicator of whether a stock is overvalued or undervalued is
the price/earnings (P/E) ratio, which relates share price to earnings per share.
222
Neil C. Rifkind, Note, Should Uninformed Shareholders Be a Threat Justifying Defensive
Action by Target Directors in Delaware?: “Just Say No” After Moore v. Wallace, 78 B.U.L. REV. 105, 143
(1998).
219
62
higher earnings in the future, managers may attempt to manipulate these signals, inflating
earnings to raise forecasted value.223
For a repurchase strategy to have the effect of raising earnings per share for the
remaining shareholders, it must provide better share value than that realized by
reinvesting the repurchase money. For example, suppose that X corporation is a mature
business in a mature industry that by reinvesting its capital could realize an after-tax
return of 7%. If X was to repurchase its shares for eight times earnings, then every $1
spent on the repurchase of shares will make 12.5 cents of earnings to the non-selling
shareholders. As a result X’s earnings per share will be higher than if the earnings were
plowed back.
V.
The Bird-In-The-Hand Theory
It has been further suggested that shareholders prefer dividends to the retention of
funds by a corporation, because dividends are a “bird in the hand.”224 The theory is that
shareholders consider it safer to take the cash dividend than to leave it up to the
corporation to invest the excess funds internally225.
Market professionals and legal scholars often criticize this theory for failing to
acknowledge that investors have already weighted this risk factor.226 These scholars
propose that market prices already include what investors consider as risk elements, thus
making the bird-in-the-hand theory redundant.
223
See id. at 143. But see id. at 143 n.247 (arguing that market participants already take into
account earnings inflation).
224
Booth, supra note 214, at 1065.
225
Fischel, Dividend Policy, supra note 202, at 702-3.
226
Booth, supra note 214, at 1065.
63
VI.
The Takeover Defense Theory
Some central features of corporate planning include stock acquisitions as
preventive and defensive measures.
Stock acquisitions are sometime made as a preventive measure, to reduce issuer
vulnerability to unsolicited acquisition bids.227 Target corporations228 sometimes employ
defensive tactics in an effort to thwart a pending hostile bid. Increasingly, target boards
have resorted to repurchase programs as means of defeating hostile bids, either through
enhancing an existing control position of a loyal shareholder or raising the bidder’s
cost.229
Where a strong control block already exists, repurchasing public stock will have
the effect of increasing the percentage ownership of the non-selling control group.230
Enhancing the control of a loyal party (management or management loyalist who are
unlikely to tender to the bidder) increases the probability that the bid will ultimately fail.
In the absence of a strong control block, the issuer’s self tender, standing alone,
will not defeat a hostile bid but in effect will assist the hostile bidder. By repurchasing
shares, the issuer will have reduced the amount of shares the bidder must acquire to
realize control (because it reduced its outstanding capitalization).231
227
Shmidler & Sheinfeld, supra note 157, at 326.
A company that is the object of a takeover attempt is a target company. The Dictionary of
Financial Risk Management, available at http://riskinstitute.ch/.
229
GILSON & BLACK, supra note 24, at 762, citing Nathan & Sobel, Corporate Stock Repurchases
in the Context of Unsolicited Takeover Bids, 35 BUS. LAW. 1545 (1980).
230
See id. at 762 (“[R]epurchases may increase the percentage of shares held by management or
another friendly group and effectively force the unsolicited bidder to acquire a supermajority of the
remaining shares to succeed.”); Louis P. Friedman, Note, Defensive Stock Repurchase Programs: Tender
Offers in Need of Regulation, 38 STAN. L. REV. 535 (1986).
231
Nathan & Sobel, supra note 229; Friedman, supra note 230, at 562:
228
Stock repurchases could facilitate a hostile takeover, since they would merely
reduce the number of shares a third party would need to effectuate its design.
The success of the defensive-repurchase tactic depends on a block of friendly
64
Under both Delaware and Israeli corporation law, repurchased shares become
treasury stock which cannot be voted by the target managers.232 As a result, defensive
stock repurchases automatically increase the percentage of voting stock that is owned
by the hostile bidder and may, thus, represent a somewhat risky strategy. 233 However,
in light of the Security and Exchange Commission’s tender offer rules, which require
the bidder to reveal its pre-offer stake in the target,234 management can avoid
particularly risky stock repurchases.
On the other hand, because a repurchase program creates price pressure,235 it
can still be used to defend against a hostile takeover threat. A repurchase program
may thwart a pending bid by raising the bidding price beyond what the bidder is
willing to pay, or if nothing else, causing the bidder to raise the price.236 The
repurchase program has the effect of increasing the cost to the bidder who is
seeking to acquire a controlling interest, without increasing the value of the target.
The larger the price pressure effect is, the less attractive the target becomes, and
the more likely it is that the bidder, or potential acquirer, will abandon the hostile
bid.
shareholders whose percentage ownership would increase as a result of the
smaller number of shares outstanding . . . .
232
DEL. CODE ANN. tit. 8 § 160(c) (2001). The Companies Law, 1999, 308 S.H. 189.
See Michael Bradley & Michael Rosenzweig, Defensive Stock Repurchases, 99 HARV. L. REV.
1378, 1379 n.2 (1986) (“The riskiness of the repurchase strategy will in fact turn on the relative holdings of
the outside bidder and target managers and loyalists.”).
234
17 C.F.R. § 240.14d-100 (2001).
235
See infra pp. 60-61.
236
“For example, an issuer self-tender at a substantial premium over market may well confuse the
bidder, disrupt its planning and timing and cause it to reassess the desirability of the acquisition”. GILSON
& BLACK, supra note 24, at 763, citing Nathan & Sobel, supra note 229. However, Nathan and Sobel
question whether in the absence of an inside non-selling control group (whose position will be enhanced by
the self tender), the issuer’s self tender, standing alone, will be able to achieve even the goal of causing the
bidder to raise his original price. See id. at 762.
233
65
However, as Gilson and Black point out, 237
[M]ore often than not the bidder will have more pricing
flexibility and frequently more pricing capability than the issuer.
Many issuers are subject to financial covenants that depend
upon maintaining certain debt/equity ratios, and more
fundamentally, even the most strongly capitalized issuer can
only buy back so much of its stock within the limits of sound
financial planning.
VII.
Greenmail238
The corporation might resort to repurchasing the stock from the hostile bidder for
a premium (greenmail), in settlement for having the bidder terminate its efforts take over
the company. The economic effect on the corporation would be a reduction in firm value
to the extent of the premium paid out to the bidder (or other hostile shareholders). The
non-selling shareholders (all shareholders but for the bidder)239 will effectively pay for
the premium through a decrease in the value of their equity.240
237
See id. at 763.
The term “greenmail” describes the practice of accumulating a large percentage of a company’s
shares (enough to present a threat of control), in order to sell them back to the company at an inflated price.
239
Since a selective stock repurchase is principally designed to remove a threat to the corporation,
other shareholders do not have an opportunity to participate in it. Naturally, a pro rata repurchase offered to
all shareholders will not accomplish the goal of eradicating an unfriendly shareholder. See Nathan & Sobel,
supra note 229, at 1554.
240
Bradley & Rosenzweig, supra note 233, at 1395. See also Friedman, supra note 230, at 560
n.86 (reviewing finance theories that use cumulative abnormal returns (abnormal returns measure the
change in a stock’s price relative to price changes in an assorted market portfolio) to empirically test the
effects of greenmail on shareholders’ wealth:
238
[R]ecent studies have found that nonparticipating shareholders suffer
negative abnormal returns when targeted repurchases effectively kill an offer.
See The Office of the Chief Economist of the SEC, The Impact of Targeted
Share Repurchases (Greenmail) on Stock Prices (Sept. 11, 1984), reprinted
in [1984-1985 Transfer Binder] FED. SEC. L. REP. (CCH) P83, 713 (overall
net-of-market abnormal return of negative 3.7% represents direct cost of
greenmail payment and indirect cost of lost putative gains from change in
control) . . . Dann & DeAngelo, Standstill Agreements, Privately Negotiated
Stock Repurchases, and the Market for Corporate Control, 11 J. FIN. ECON.
275 (1983) (block repurchases at a premium produce negative abnormal
returns . . . ).
However, Andrei Shleifer and Robert Vishny argue that greenmail has a positive effect on the
wealth of shareholders in that it can be an effective form of signal concerning target management’s
66
However, while both greenmail and dividend distributions cause a reduction in
the firm value to the extent of the premium that is paid out, dividends are paid to all
shareholders in proportion to their holdings so that all shareholders bear a proportionate
share of the capital loss that finances the dividend.241
i.
Greenmail As An Archetypical Management Entrenching
Defensive Tactic: The Agency Conflict
The use of greenmail to defeat unwanted tender offers has come under attack,
among other things, for being used by target management to entrench themselves and
retain control, regardless of the corporate welfare and that of its shareholders. This is
viewed as another agency cost of the conflict of interest between management and other
corporate players.242
Several greenmail studies that examined the effect of greenmail on returns,
suggest that greenmail is a predominantly entrenching device.243 By using greenmail,
information. They defend greenmail as a potential source for gains to target shareholders by drawing
additional bidders into the bidding contest, thereby causing price pressure. Andrei Shleifer & Robert
Vishny, Greenmail, White Knights And Shareholder Interest, 17 RAND J. ECON. 293 (1986).
241
Larry Dann & Harry DeAngelo, Standstill Agreements, Privately Negotiated Stock Purchases,
and the Market for Corporate control, 11 FIN. ECON. 275, 294 (1983). And see Bradley & Rosenzweig,
supra note 233, at 1396. These studies reported statistically significant negative abnormal returns over the
several days surrounding the announcement of the repurchase. In contrast, studies on the impact of general
stock repurchase programs on the target’s stock show substantial positive abnormal returns. See Theo
Vermaelen, Common Stock Repurchases and Market Signaling: An Empirical Study, 9 J. FIN. ECON. 139
(1981), and see Ronald Masulis, Stock Repurchases By Tender Offer: An Analysis of the Causes of
Common Stock Price Changes, 35 J. FIN. 305 (1981).
242
See GILSON & BLACK, supra note 24, at 787 (“That the control issues puts target management
in a position where its interests and those of the shareholders conflict is apparent; that management
succumbs to the conflict when it engages in greenmail seemed supported by the empirical data.”).
243
Michael Bradley & Larry Wakefield, The Wealth Effect Of Target Share Repurchases, 11 J.
FIN. ECON. 301, 308 (1983). But see James Ang & Alan Tucker, The Shareholders Wealth Effects of
Corporate Greenmail, 11 J. FIN. RES. 265 (1988) and other studies cited in GILSON & BLACK, supra note
24, at 788 for the proposition that greenmail has the same effect as other successful defensive tactics: “if
the defeated bid is not followed by a successful acquisition, the gain that remains after the greenmail
payment disappears. Thus some greenmail payments benefit shareholders (if they lead to a subsequent
offer) and some greenmail payments entrench management (if they do not).”); on greenmail and the
management entrenchment hypothesis see Jonathan R. Macey & Fred S. McChesney, A Theoretical
67
management effectively spends corporate funds to deprive the shareholders the
opportunity to receive a premium offer that would otherwise be available to them by
selling their shares into a takeover bid at a high price.244 At the same time, management
arguably spends more corporate assets (for the share buyback) than the market
presently believes the shares are worth.245
VIII. Stock Manipulations And The Creditor Expropriation Theory
i.
Stock Manipulations
Critics often attack repurchase plans and dividend distributions as manipulative
tools applied with the intention of adjusting stock prices. This was one of the main
concerns the Israeli draftsman expressed with regard to lifting the limitations on share
repurchasing.
In October 1983, Israel’s economy underwent a stock market crisis as a direct
result of stock manipulations practiced by a cluster of local banks. The banks
continuously acquired bank-stocks,246 contrary to market inclinations, driving stock
prices to unreal values. In this process, the banks exhausted a dangerous portion of their
resources, bringing the whole banking system and the stock markets to the verge of
collapse. As a result, the Israeli government shut down all stock market activity for a
period of three weeks to formulate a comprehensive plan to prevent mass cash
Analysis of Corporate Greenmail, 95 YALE L.J. 13 (1985), and Note, Greenmail: Targeted Stock
Repurchases and the Management-Entrenchment Hypothesis, 98 HARV. L. REV. 1045 (1985).
244
GILSON & BLACK, supra note 24, at 786.
245
Studies confirm that target companies earn negative abnormal returns when they announce the
payment of greenmail. Id. at 787.
246
Though the corporation law at that time generally contained a prohibition on buybacks, the
banks took advantage of a loophole in the Companies Ordinance, 1983, which did not clearly prohibit share
repurchases by subsidiary corporations.
68
withdrawal by the public, whose stocks value plunged dramatically, and which provided
the main security for the credits which were advanced to repurchase these stocks.247
Unsurprisingly, during the 1990s, when Israeli draftsmen sought to do away with
the general prohibition on stock repurchasing, their proposals met a loud dissent from the
financial community. Nonetheless, in the 1999 version of the Companies Law, these
general limitations were deleted and in their place a cautious formula for distribution was
approved.
ii.
Creditor Expropriation Theory
Another opposition is directed, in a more general fashion, towards liberal
distribution statutes because they under-protect creditors. The creditor expropriation
theory posits that new debt issuance causes wealth transfers from the creditors to the
shareholders.
Lily Kahng, for example, rationalizes the correlation observed between new debt
issuances and share value increases as a wealth transfer from bondholders to
shareholders.248 The wealth transfer hypothesis submits that increasing the risk of the
outstanding debt by issuing large amounts of new debt, decreases the value of the
outstanding debt, and increases the value of the outstanding stock.249
247
See THE BEYSKI COMM. REPORT ON THE BANKS STOCK MANIPULATION AFFAIR, April 1986,
335 (Isr.); BAHAT, supra note 47, at 452; Shmidler & Sheinfeld, supra note 157, at 327.
248
Lily Kahng, Resurrecting the General Utilities Doctrine, 39 B.C. L. REV. 1087, 1104 n.68
(1998), citing RONALD W. MASULIS, THE DEBT/EQUITY CHOICE, 35-46 (1988). See also, GILSON &
BLACK, supra note 24, at 626.
249
GILSON & BLACK, supra note 24, at 626.
69
IX.
Stock Redemptions
i.
Redemptions Occurring Pursuant To Previously Negotiated
Arrangements
A corporation which redeems its own shares pursuant to a previously negotiated
arrangement, is not purchasing its shares in the usual sense of the word. That is, the term
“repurchase” suggests that the corporation is reacquiring stock, which was not designated
as redeemable from the onset, through a self-tender, an open-market repurchase, or a
private repurchase.
a.
Redeemable Stocks And Preferred Stock
A corporation may choose to include in its charter a provision that its common
stock be redeemable at the option of the corporation.
Delaware’s G.C.L., section 151(b), expressly provides that, “[a]ny stock of any
class or series may be made subject to redemption by the corporation at its option or at
the option of the holders of such stock or upon the happening of a specified event.”250
Similarly, the Companies Law, section 312(a), provides for the issuance of
redeemable common stock251 and their redemption.252
In many respects, preferred stockholders resemble bondholders rather than
common stockholders. They have lent the business money in return for a flat mandatory
dividend. The dividend is paid to the preferred stockholder every set term, regardless of
whether it pays a dividend to its common stockholders. By redeeming the preferred
250
DEL. CODE ANN. tit. 8 § 151(b) (2001). See also John C. Coates IV, “Fair Value” as an
Avoidable Rule of Corporate Law: Minority Discounts in Conflict Transactions, 147 U. PA. L. REV. 1251,
1290 (1999).
251
The Companies Law, 1999, 312 (b), (d) S.H. 189.
252
See also BAHAT, supra note 47, at 422 (redeemable stocks are not subject to general distribution
limitations because the creditors do not rely on them as part of the equity cushion).
70
stockholders, the corporation can terminate its obligation to make such compulsory
dividend payments.
Thus, management might find it worthwhile redeeming the bondholders when the
corporation no longer needs the capital that is represented by their contributions.
b.
Redemptions
For
The
Purpose
Of
Preserving
Ownership Proportions
Repurchasing stock from the shareholders may also be exercised for the purpose
of preserving the proportionate holdings of the remaining shareholders when one of the
managers or shareholders leaves the business, dies, or retires, particularly in close
corporations. By repurchasing his or her shares, the corporation avoids the kind of control
struggle that might be triggered if the residual shareholders competed with each other for
the shares. For this reason, shareholders in closely held corporations often sign a
redemption agreement in advance.
ii.
Redemption Clauses As Poison Pills
Poison pill provisions253 have become a popular method to deter hostile bidders
from trying to obtain control over a corporation. A poison pill will effectively dilute any
common stock position that the hostile acquirer might establish, thereby, making the
target less attractive.
A redemption plan can be installed as a poison pill to deter a takeover attempt.254
Poison pill redemption plans are sometime referred to as “put” plans. They come into
253
Poison pill plans are a type of shark repellent provisions designed to deter or defeat a hostile
takeover. The Dictionary of Financial Risk Management, available at http://riskinstitute.ch/.
254
See GILSON & BLACK, supra note 24, at 738-39; O’KELLEY & THOMPSON, supra note 7, at
818:
[Poison pill] rights lie unused and almost worthless until triggered by a
hostile acquisition. At that point the rights explode in a way that makes the
71
play if a bidder buys some, but not all, of the target’s shares. Redemption plans focus on
the position of the minority non-tendering shareholders255 in providing the target
shareholders the right to sell back to the corporation their remaining shares in the target,
at a “fair price”.256
Stock redemption plans are reportedly some of the most effective defenses a
corporation can adopt. Gilson and Black describe redemption rights as more effective
deterrents than others because they have the potential for placing an enormous added
financial cost on a hostile bidder,257
If a potential offeror contemplates an offer for less than 100% of
the target’s stock, a right of redemption provision may remove
control over the size of an offeror’s total investment from his
hands. Because the shareholders may in effect force a secondstep transaction by exercising their right to require redemption,
they, and not the offeror, have the last word on the number of
shares ultimately acquired and, if the provision’s pricing formula
could yield a price higher than the offeror, on the price that is
paid . . . . If the pricing formula assures holdouts a price no
lower than the tender offer and provides the potential of a higher
price, target shareholders will be given an incentive not to tender
in the original offer.
acquisition particularly painful for the bidder to digest. In the more popular
versions of the pill, the target shareholders get the right to redeem their shares
in the target company for a price well above market price . . . . The acquiring
company finds itself with a target corporation depleted of assets or fills with
new obligations.
255
The concept of redemption provisions as a put plan originated from the English Companies Act
to allow minority shareholders to require the target company to acquire their shares at a formula price that
equals or exceeds the price paid by the bidder. It is effective against two-tier front-loaded tender offers
where shareholders normally fear that if they do not tender they will be later cashed out in a back-end
merger for less than initially offered. Weiss, Elliott J., Balancing Interests in Cash-Out Mergers: The
Promise of Weinberger v. UOP, Inc., 8 DEL. J. CORP. L. 1, 58 n.357 (1983).
256
A “fair price” is essentially the price that the corporation’s directors believe is fair. Typically
will be equal or greater than the highest price paid by the bidder for any shares acquired during the offer.
Note, this type of redemption is distinguishable from redemption of redeemable stocks discussed above.
257
GILSON & BLACK, supra note 24, at 738-39.
72
Gilson and Black emphasize that the effectiveness of redemption plans as
deterrence mechanisms lies not only in their ability to increase the price of the entire
acquisition for the offeror, but also remove the offeror’s alternative not to proceed with a
second-step transaction if the cost appears too great, or its benefits too small.258 Critics
consider the benefits of redemption plans as a defensive tactic alongside with their perils.
As with other defensive tactics, redemption plans pose the danger that management will
use them to secure their own positions by reducing the likelihood of future tender offers
at a premium to the shareholders. Management’s increased security has been thought to
come at the expense of the shareholders.259
The legitimacy of poison pill redemption plans in Israel is doubtful. Though the
Companies Law allows the reacquisition of stock260 (subject to limitations),
management’s power to thwart bids is generally carefully scrutinized.261 In addition, the
language in section 312 of the Companies Law,262 seems to suggest that rights of
redemption are available solely to redeemable shares.263
258
Id. at 778.
Id. at 778.
260
A corporation may launch a repurchase plan as a defensive response to a hostile bid, however,
such plan will have to comply with general distributions principles.
261
See GROSS, supra note 40, at p.375. Though the new Companies Law represents a shift from
the conservative British version of the Companies Ordinance, it fails to draw a clear picture with respect to
the continuation of some of its predecessors’ restrictive approaches to takeovers. For instance in the U.K.
“the target company cannot take any action that would “frustrate a bid”, i.e., no poison pills, no ESOPs, no
stock repurchase programs, no sale of assets, no leveraged special dividends unless approved by
stockholders.” Colloquium, What Business Will Look For In Corporate Law In The Twenty-First Century,
25 DEL. J. CORP. L. 6, 10-11 (2000). And see Bernard S. Black & John C. Coffee, Hail Britannia?:
Institutional Investor Behavior Under Limited Regulation, 92 MICH. L. REV. 1997, 2026 (1994) (“In
Britain, defensive powers were limited to begin with and changed little over the decade. There simply are
no poison pills, targeted share placements, or lock-up options by which target managers can block a tender
offer. The restrictive British approach to takeover defenses may reflect, in part, the political power of
British institutions.”).
262
The Companies Law, 1999, 312 S.H. 189.
263
The shares must have been issued as redeemable shares from the onset. The Companies Law,
1999, 312(d) S.H. 189. See also BAHAT, supra note 47, at 449 (redeemable shares do not appear in the
capital account where the corporation’s stock capital appears, unless redemption rights have been limited to
the time of dissolution, after all outstanding debt have been paid).
259
73
In the absence of more clarifying notes, redemption of common stocks as a
takeover defense method must be seen as events subsisting outside the scope of section
312. Until the court sheds some light on the subject, it may be that common stock
redemptions will be examined under the general requirements for distributions.
74
CHAPTER 6
RESTRICTIONS ON DIVIDEND DISTRIBUTIONS
AND SHARE REPURCHASES
If those with no personal liability could legally withdraw their original investment
at any time, they could deprive creditors of the protective cushion that the invested
capital arguably provides, that on which they may have relied when advancing money to
the corporation. The creditors would further be injures if circumstances permitted
unscrupulous equity holders to withdraw, without restrictions, money representing not
only their investment, but also that obtained through borrowings. For this reason,
corporate law has long restricted the right of corporations to pay dividends and buy back
equity.
As previously discussed, share repurchase and dividends have similar effects on
the corporation’s capital. The corporation pays for the shares with corporate asset,
leaving fewer assets in the corporation to guarantee the payment of its debts. Thus far, it
is understandable why creditors ideally want to require the corporation to maintain
substantial assets throughout the life of the debt, prevent the corporation from placing
encumbrances on these assets, and limit payouts to shareholders. These objectives are
sustained, to some extent, by limitations posed through the corporate law system.
I.
Restrictive Covenants
Smith and Warner addressed the role of restrictive covenants in the conflict of
interest between shareholders, management, and the firm’s creditors in 1979. They wrote
74
75
that “[w]ith risky debt outstanding, stockholders actions aimed at maximizing the value
of their equity claim can result in a reduction in the value of both the firm and its
outstanding bonds.”264
As previously discussed, legal capital theories suggest that once the debt has been
issued to the corporation the return to shareholders from pursuing risky strategies
increases by virtue of the disproportionate allocation of risk between the shareholders and
the debtholders.265 It is generally thought, though, that debtholders anticipate riskincreasing behavior when negotiating the terms of the debt.266 Debtholders may demand
an interest rate that reflects the anticipated increase in risk, and/or put restrictive
covenants into place that limit the corporation’s ability to make decisions that are risky in
fashion.267
Both parties, investors and managers, have incentives to make arrangements that
reduce risk and thus reduce the premium they must pay to debt claimants.268 Bond
covenants are considered to be in most instances the most suitable fashion to reduce
monitoring costs over the corporation.269
264
Clifford W. Smith, Jr., & Jerold B. Warner, On Financial Contracting: an Analysis of Bond
Covenants, 7. J. FIN. ECON. 117 (1979).
265
Fischel, Lender Liability, supra note 31, at 131.
266
GILSON & BLACK, supra note 24, at 245.
267
Id. at 245-46; George G. Triantis & Ronald J. Daniels, The Role of Debt in Interactive
Corporate Governance, 83 CAL. L. REV. 1073, 1093 (“Current corporate scholarship explains covenants as
a means of bonding the commitment of the firm to refrain from behavior that redistributes wealth from
debtholders to shareholders or from investors as a group to managers.”).
268
Frank H. Easterbrook & Daniel R. Fischel, Limited Liability and the Corporation, 52 U. CHI.
L. REV. 89, 105 (1985). See also id. (“Managers will take steps to reduce risk only so long as the gains
from risk reduction exceed the costs.”).
269
Jonathan R. Macey & Geoffrey P. Miller, The Plaintiffs’ Attorney’s Role in Class Action and
Derivative Litigation: Economic Analysis and Recommendations for Reform, 58 U. CHI. L. REV. 1, 15-16
(1991):
Where monitoring costs are high, the optimal strategy may be for the agent to
engage in some form of bonding to assure the principal that the agent will
carry out her duty to the principal faithfully even in the absence of effective
monitoring. Such bonding can be by means of explicit contracts, as in the
76
II.
Statutory Limitations
Both Delaware’s G.C.L. and Israel’s Companies Law, place restrictions on the
ability of corporations to deplete their assets through wealth distributions to
shareholders.270
i.
Statutory Limitations On Dividends
As discussed above, a Delaware corporation may pay dividends either out of the
earned surplus account271 or the unearned surplus,272 as long as the capital of the
corporation remains intact. In addition, Delaware subscribes the payment of nimble
dividends.273
Israel provides for payment of dividends out of the earned surplus account,274
provided that the distribution does not render the corporation unable to pay its debts.275 In
addition, the Companies Law also allows nimble dividends.276 However, in distinct
difference to Delaware, Israel prohibits distributions out of any and all of the stock
capital.277
ii.
Statutory Limitations On Repurchases
With respect to share repurchase, an improper repurchase is one that inevitably
impairs the corporation’s capital.
case of bond covenants, or by implicit structural features of the principalagent relationship.
270
DEL. CODE ANN. tit. 8 § 170(a) (2001); Mark E. Van Der Weide, Against Fiduciary Duties to
Corporate Stakeholders, 21 DEL. J. CORP. L. 27, 50 (1996).
271
DEL. CODE ANN. tit. 8 § 170(1) (2001).
272
Id. § 170(2).
273
See discussion infra p. 40.
274
The Companies Law, 1999, 302 S.H. 189.
275
Id.
276
Id. § 302(b).
277
The consideration received for shares and any premiums thereof.
77
Section 160(a) of Delaware’s G.C.L.278 provides that
Every corporation may purchase, redeem . . . acquire . . . its own
shares; provided, however, that no corporation shall:
(1) Purchase or redeem its own shares of capital stock . . . when
the capital of the corporation is impaired or when such purchase
or redemption would cause any impairment of the capital of the
corporation . . . .
The Delaware code furnishes the board of directors with broad discretion in
dealing with the corporation’s own stock. At the same time, the code outlines the
marginal limitations of the board’s authority. A repurchase is deemed unlawful when it
instigates the impairment of capital. The corporation’s capital would be impaired when
the repurchase price surpasses the amount of the corporation’s surplus.279 Generally, a
share repurchase will most likely be forbidden if a dividend of the same amount would be
forbidden.
Israel has only recently removed the general prohibition on stock buybacks. The
1999 version of the Companies Law includes the practice of repurchasing stock in the
definition for “distribution”.280 As for statutory treatment, the explanatory notes make it
278
DEL. CODE ANN. tit. 8 § 160 (2001).
“Surplus” being, the excess of net assets over the par value of the corporation’s issued stock.
See also id. § 160 statutory notes:
279
This section is an authorization for a corporation to use its property for the
purchase of its own capital stock if such use will not impair its capital. Alcott
v. Hyman (citation omitted).
Impairment of capital means its reduction below amount represented by
outstanding stock --The impairment of the capital of a company, as used in
this section, means the reduction of the amount of the assets of the company
below the amount represented by the aggregate outstanding shares of the
capital stock of the company In re International Radiator Co. (citation
omitted).
See further relevant citations Id. (DEL. CODE ANN. tit. 8 § 160 statutory notes (2001), In re Motels
of Am., Inc., 146 Bankr. 542 (Bankr. D. Del. 1992), and Klang, 702 A.2d at 150.
280
The Companies Law, 1999, 301 S.H. 189.
78
abundantly clear that share repurchases and dividend distributions will be treated in the
same way subject to the general requirements for making distributions.281
iii.
Insolvency Test
Entirely apart from the surplus or impairment of capital standards, both Delaware
and Israel generally prohibit the distribution of dividends that would consequently leave
the corporation insolvent.282 A share repurchase or a dividend distribution made at a point
where the corporation was insolvent or that caused the corporation to enter insolvency
will be deemed illegal.
In Delaware, the prohibition on dividends or repurchases that would lead to
insolvency is not contained in the corporation’s statutes themselves.283 There is some
uncertainty as to what mechanism Delaware courts will apply in evaluating whether a
corporation has become insolvent.284 Mechanisms for determining insolvency may
include equitable insolvency (the inability to pay debts as they become due),285 balance
sheet insolvency, or bankruptcy insolvency (balance sheet negative net worth; where
reported liabilities exceed the book value of assets),286 or other statutory definitions.287
281
The Companies Bill, explanatory notes § 345; GROSS, supra note 40, at 335.
The courts will intervene in circumstances where dissemination of assets substantially
diminishes creditors’ security. See DEL. CODE ANN. tit. 8 § 160 statutory notes (2001) citing Pasotti v.
United States Guardian Corp. 18 Del. Ch. 1, 156 A. 255 (1931), and In re International Radiator Co., 10
Del. Ch. 358, 92 A. 255 (1914). See also The Companies Law, 1999, 302 S.H. 189.
283
The prohibition appears in non-corporation statues, which protect creditors. See Roberts &
Pivnick, supra note 147, at 67-68 (“Delaware laws provide that no dividend shall be paid if the dividend
exceeds the surplus -- the DGCL, contains no insolvency language. . . . And while no solvency test exists
for Delaware distributions, a distribution may be set aside as fraudulent.”). See also DEL. CODE ANN. tit.
8 § 170(a) (2001).
284
See Barondes, supra note 9, at 49 n.10.
285
Harvey R. Miller, Corporate Governance in Chapter 11: The Fiduciary Relationship Between
Directors and Stockholders of Solvent and Insolvent Corporations, 23 SETON HALL L. REV. 1467, 1480
n.57 (1993).
286
Id. at 1480 n.58.
287
E.g., the Bankruptcy Code’s definition [11 U.S.C. § 101(32)(2001)], the Uniform Fraudulent
Conveyance Act’s definition [UNIF. FRAUDULENT CONVEYANCE ACT § 2(1), 7A U.L.A. 442(2001)], the
Uniform Fraudulent Transfer Act’s definition [UNIF. FRAUDULENT TRANSFER ACT § 2(a), (b), 7A U.L.A.
648 (2001)].
282
79
Some writers support the proposition that a Delaware corporation may be
considered insolvent either when its liabilities exceed its assets, or when the corporation
is unable to meet its current obligations arising in the ordinary course of business.288 In
Geyer v. Ingersoll Publications Co.,289 the Chancery Court of Delaware declared that in
the context of examining directors’ liability for unlawful distributions insolvency could
occur under either a negative net assets test or a cash flow test.290
Other writers suggest that there is some evidence that Delaware courts are likely
to favor equitable insolvency, which like the Israeli formula, focuses on the corporation’s
inability to pay its debts as they become due.291
The Companies Law expressly integrates an equitable insolvency test in the
general test for distribution. Section 302(a) of the Companies Law provides that a
distribution could be deemed unlawful where it raises “reasonable concern”292 that it
could ultimately lead the corporation into a position where it is unable to pay its debts
(outstanding and foreseeable) as they become due.293
288
FOLK ON THE DELAWARE GENERAL CORPORATION LAW: FUNDAMENTALS § 291.2 at 749
(Edward P. Welch & Andrew J. Turezyn eds., 1997) cited in Barondes, supra note 9, at 49 n.10.
289
621 A.2d 784 (Del. Ch. 1992).
290
See id. (referencing Webster’s definition of insolvency. Webster’s Ninth New Collegiate
Dictionary 626 (1988), citing the 1899 case of McDonald v. Williams for the proposition that that a
corporation is as a matter of fact insolvent once “the value of its assets has sunk below the amount of its
debts”. McDonald v. Williams, 174 U.S. 403, 43 L. Ed. 1022, 19 S. Ct. 743 (1899)).
291
See Andrew D. Shaffer, Corporate Fiduciary - Insolvent: The Fiduciary Relationship Your
Corporate Law Professor (Should Have) Warned You About, 8 AM. BANKR. INST. L. REV. 479, 515 (2000).
292
The “reasonable concern” element does not require a showing of certainty, or even near
certainty, that the distribution will hinder the corporation’s ability to meet its obligations. What is required
is a showing that there is a real possibility that the distribution will generate genuine difficulties in doing
so. See GROSS, supra note 40, at 345. The reasonable concern test represents a conservative approach
because it accepts, as sufficient, evidence that is based on the average probability that the distribution will
negatively affect the financial stability of the corporation. See id. The reasonable concern test is criticized
for placing a heavy burden on management, and for, arguably, providing too wide a protection to the
creditors. For one thing, once the corporation reaches financial distress, the court will scrutinize
management’s behavior, in hindsight. The creditors will typically claim that the distribution was illegal
because it resulted in financial distress. Second, the test ultimately requires management to obtain financial
forecasts which are indeterminate parameters in nature. Id.
293
The Companies Law, 1999, 302(a) S.H. 189.
80
III.
Limitations Imposed By Case Law
i.
Imposing Fiduciary Duties On Directors Of Insolvent Or Near
Insolvent Corporations
It is generally accepted that under U.S. law, the directors of a solvent corporation
do not owe the creditors any duty other than duties arising with respect to compliance
with the terms of the debt.294 The rationale is that because the relationship between the
bondholders and the corporation is contractual in nature, the bondholders, in theory, have
had an opportunity to negotiate the terms of that relationship, and incorporate any
necessary or desired protections into the indenture.295
294
See David Thomson, Directors, Creditors and Insolvency: A Fiduciary Duty or a Duty Not to
Oppress?, 58 U.T. FAC. L. REV. 31, 44 (2000) citing Webb v. Cash, 35 Wyo. 398 (1926):
[I]n Webb v. Cash, the Supreme Court of Wyoming held that it is difficult to
perceive upon what principle a director of a corporation can be considered a
trustee of its creditors. He is selected by the shareholders, not by creditors; he
has no contractual relation with the latter; he represents a distinct entity, the
corporation; and his relations to its creditors is exactly the same as the agent
of an individual bears to creditors of such individual; and it is not pretended
that in the latter case the agent would be the trustee of the creditors of his
principal. And we think that by the great weight of authority such trust
relation is distinctly repudiated, when the corporation is a going concern.
And see Nicholson, supra note 31, at 574-76:
Where a corporation is solvent, Delaware courts have held that the only
duty directors owe bondholders is to adhere to the terms of the bond
indenture or contractual agreement.
...
In the context of the solvent corporation, it is settled Delaware law that
directors do not owe bondholders any duty other than compliance with the
terms of the bond indenture. . . . That contractual relationship generally
recognizes that bondholders have lent money to the corporation and, in
return, are entitled to the repayment of their loan plus interest.
See also Katz v. Oak Indus., Inc., 508 A.2d 873, 879 (Del. Ch. 1986) (the relationship between the
corporation and the holders of its debt securities, even convertible debt securities, is contractual in nature);
Harff v. Kerkorian, 324 A.2d 215, 222 (Del. Ch. 1974), rev'd on other grounds, 347 A.2d 133 (Del. 1975)
(“It is apparent that unless there are special circumstances which affect the rights of the debenture holders
as creditors of the corporation . . . the rights of the debenture holders are confined to the terms of the
Indenture Agreement pursuant to which the debentures were issued.”); See generally BAHAT, supra note 47,
at 687-90.
295
Nicholson, supra note 31, at 576; BAHAT, supra note 47, at 302.
81
Delaware’s Supreme Court recently articulated this principle in the case of
Simons v. Cogan,296 where Judge Walsh J., for the Court, held that a fiduciary duty is not
owed to holders of convertible debentures:297
Before a fiduciary duty arises, an existing property right or
equitable interest supporting such a duty must exist . . . . Until
the debenture is converted into stock the convertible debenture
holder acquires no equitable interest, and remains a creditor of
the corporation whose interests are protected by the contractual
terms of the indenture.
In sharp contrast, once a Delaware corporation becomes insolvent or, as recent
case law suggests, is on the brink of insolvency, the directors are held accountable to the
corporation’s creditors as well as to its shareholders.298
That directors owe creditors fiduciary duties at the point of insolvency has long
been recognized in the U.S. under the trust fund doctrine. The trust fund doctrine was
developed in a trilogy of cases, discussing (with varying degrees of acceptance) the
doctrine299 first articulated in the landmark case of Wood v. Dummer.300 The court in
Wood v. Dummer held that the capital stock of a corporation comprises “a trust fund for
the payment of all the debts of the corporation.” The court went on to say that,
The bill-holders and other creditors have the first claims upon
[the capital stock of the corporation]; and the stockholders have
no rights, until all the other creditors are satisfied . . . . On a
296
549 A.2d 300 (1988).
Id.
298
Nicholson, supra note 31, at 574 (“[W]hen a corporation becomes insolvent, Delaware courts
say that directors become de facto trustees of the corporate assets for the benefit of creditors. Thus, a
corporation’s insolvency shifts the board’s obligations from its shareholders to its creditors.”). And see
Credit Lyonnais Bank Netherland, N.V. v. Pathe Communications Corp., 1991 Del. Ch. LEXIS 215 (on
directors’ duties at the brink of insolvency).
299
See Asmussen v. Quaker City Corp., 156 A. 180 (Del. Ch. 1931), and Pennsylvania Co. for
Insurances v. South Broad Street Theatre Co., 174 A. 112 (Del. Ch. 1934) (the courts rejected its
application to Delaware corporations). And see Bovay v. H.M. Byllesby & Co., 38 A.2d 808 (Delaware’s
Supreme Court acknowledged the doctrine, but limited its application to Delaware corporations). See also
generally Nicholson, supra note 31, at 580-81.
300
30 F.Cas. 435.
297
82
dissolution of the corporation, the bill-holders and the
stockholders have each equitable claims, but those of the billholders possess . . . . a prior exclusive equity.301
This principle was widely reiterated in cases that followed.302
The Supreme Court of Delaware recognized the trust fund doctrine in 1944 in the
case of Bovay v. H.M. Byllesby & Co.,303 stating that,
An insolvent corporation is civilly dead in the sense that its
property may be administered in equity as a trust fund for the
benefit of creditors. The fact which creates the trust is the
insolvency, and when that fact is established, the trust arises,
and the legality of the acts thereafter performed will be decided
by very different principles than in the case of solvency.
Having made that statement, the court qualified the fiduciary role of directors,
holding that, “corporate officers and directors, while not in strictness trustees, will . . . be
treated as though they were in fact trustees of an express and subsisting trust . . .
especially where insolvency of the corporation is the result of their wrongdoing.”304
Since Bovay, the directors of a Delaware corporation are held to the high
standards of conduct that trustees are held to, and owe fiduciary duties to the creditors of
301
302
See id. at 436-37.
Davis v. Woolf, 147 F.2d 629, 633 (4th Cir. 1945):
[W]hen a corporation becomes insolvent, or in a failing condition, the
officers and directors no longer represent the stockholders, but by the fact of
insolvency, become trustees for the creditors, and that they then can not by
transfer of its property or payment of cash, prefer themselves or other
creditors, and that this is so, independently of any of the provisions of the
national bankruptcy law.
See also Automatic Canteen Co. of America v. Wharton, 358 F.2d 587, 590 (2nd Cir. 1966)
(“directors of an insolvent corporation occupy a fiduciary position toward the creditors, just as they do
toward the corporation when it is solvent.”).
303
38 A.2d 808, 813 (Del. 1944) (Layton C.J.) (citing McDonald v. Williams, 174 U.S. 397, 19 S.
Ct. 743, 43 L. Ed. 1022 (1899)).
304
Bovay, 38 A.2d at 820.
83
the corporation when a corporation becomes insolvent. But, the directors are not in that
sense “trustees” of corporate assets for the creditors.305
Recently, Delaware’s Court of Chancery revisited the rule that directors owe
fiduciary duties upon insolvency. In Geyer,306 the court held that the duty arises once the
corporation enters, what the panel termed, “insolvency in fact”.307 The court reiterated the
rule that “when the insolvency exception does arise, it creates fiduciary duties for
directors for the benefit of creditors.”308
In Credit Lyonnais Bank Netherland, N.V. v. Pathe Communications Corp.,309
The Court of Chancery leaped a step further by imposing fiduciary duties on directors of
Delaware corporations, even prior to the point of insolvency.310 In Credit Lyonnais,
Chancellor Allen held that when a corporation is in the “vicinity of insolvency”,311 the
directors’ duty of loyalty is owed to the corporate enterprise as a whole. The court stated
that,312
At least where a corporation is operating in the vicinity of
insolvency, a board of directors is not merely the agent of the
residue risk bearers, but owes its duty to the corporate
enterprise.
...
[The board has] an obligation to the community of interests
that sustained the corporation to exercise judgment in an
informed, good faith effort to maximize the corporation' s longterm wealth creating capacity.
305
Thomson, supra note 294, at 45; Nicholson, supra note 31, at 582.
Geyer, 621 A.2d 784.
307
The issue in Geyer was not whether fiduciary duties existed, but rather, whether the duties were
triggered when the corporation became insolvent in fact, or when statutory proceeding (such as bankruptcy)
where instigated.
308
Geyer, 621 A.2d at 787.
309
1991 Del. Ch. LEXIS 215.
310
Chancellor Allen relies on the principles of the overinvestment theory to explain why creditors
of an insolvent or near insolvent corporation should be burdened with such duties. See Credit Lyonnais,
1991 Del. Ch. LEXIS at *108 n.55.
311
See id. See also id. at *108-09.
312
Id. at *108-09.
306
84
The general rule that appears to have submerged is that the directors of a
corporation, which is in the vicinity of insolvency, owe a duty not to any particular group,
such as shareholders or creditors, but to the community of interest that impacts a
corporation at large. As such, they are to disregard the conflicting incentives of the
various claimants and must not attempt to promote the interests of one group at the
expense of another.313
The duty, as per Chancellor Allen, is to maximize the long-term wealth of the
corporation.314 However, according to earlier holdings, the appropriate time horizon to be
considered by the board of directors for the purpose of shaping corporate strategies
included long-term values and strategies as well as short-term ones.315
313
Barondes, supra note 9, at 66.
The board has an obligation to “maximize the corporation’s long-term wealth creating
capacity.” See Credit Lyonnais, 1991 Del. Ch. LEXIS at *109.
315
Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140, 1154 (Del. 1990),
314
Delaware law confers the management of the corporate enterprise to the
stockholders’ duly elected board representatives. 8 Del. C. § 141(a). The
fiduciary duty to manage a corporate enterprise includes the selection of a
time frame for achievement of corporate goals. . . . Directors are not obliged
to abandon a deliberately conceived corporate plan for a short-term
shareholder profit unless there is clearly no basis to sustain the corporate
strategy.
And see Unitrin, Inc. v. American Gen. Corp., 651 A.2d 1361, 1386 (in the context of determining
the reasonableness of a stock repurchase program) (“Distinctions among types of shareholders are neither
inappropriate nor irrelevant for a board of directors to make, e.g., distinctions between long-term
shareholders and short-term profit-takers, such as arbitrageurs, and their stockholding objectives.”). But see
Barondes, supra note 9, at 70-71(Credit Lyonnais limits the discretion of the board available under
Paramount):
Paramount was decided in 1990, before the 1991 decision in Credit
Lyonnais. Therefore, the discussion of a time horizon in the Credit Lyonnais
opinion only has meaning if it is intended to exclude a reference to another
time horizon, i.e., shorter time horizons. Since Paramount generally grants
directors the authority to select the relevant time horizon, including shorter
time horizons.
85
Up to Credit Lyonnais Delaware case law appeared to have shaped a somewhat
simple formula: while the corporation was solvent, Simons v. Cogan,316 released directors
of all but their contractual duties to bondholders.317 Once insolvency in fact occurred,
Geyer318 burdened directors with fiduciary duties to the creditors.319
Credit Lyonnais has been criticized for upsetting the dichotomy of duties between
solvency and insolvency, both in terms of the trigger mechanism and the scope of the
duty owed. One critic describes Chancellor Allen’s statement in that case as,
[R]egrettably ambiguous in its timing and scope, unrealistic in
its expectations, and lacking in a procedural enforcement
mechanism. Chancellor Allen' s holding is also unnecessarily
narrow by virtue of its limited applicability; that is, it apparently
applies only to corporations in the vicinity of insolvency and not
to those that are, in fact, insolvent.320
However, one element of Chancellor Allen’s holding appears clear to most
scholars. This versatile fiduciary duty is seemingly short-lived and confined to that
period of time when the corporation is in the vicinity of insolvency. Then, reverting to
Geyer321 once a corporation is, in fact, insolvent, directors owe a fiduciary duty only to
the creditors.322 Nonetheless, the statement in Credit Lyonnais, that the triggering event
is when the company is in the vicinity of insolvency,323 appears inconsistent with the
decision in Simons v. Cogan324and other case law,325 which pronounce that directors of
316
549 A.2d 300. Simons restated and shaped the principles of Katz v. Oak Indus., Inc., 508 A.2d
873 (Del. Ch. 1986), and Harff v. Kerkorian, 324 A.2d 215 (Del. Ch. 1974).
317
See infra pp. 80-81.
318
Geyer, 621 A.2d 784 reiterated and qualified the principles laid by Harff, 324 A.2d 215 and
Bovay, 38 A.2d 808.
319
See supra note 298 and accompanying text.
320
Nicholson, supra note 31, at 575.
321
Geyer, 621 A.2d 784.
322
Id. at 787.
323
See Credit Lyonnais, 1991 Del. Ch. LEXIS at *108.
324
Simons, 549 A.2d 300.
325
E.g., Katz, 508 A.2d 873 and Harff, 324 A.2d 215.
86
solvent corporations owe the creditors no other duties but contractual duties related to the
debt. It seems further inconsistent with Geyer326 where Vice Chancellor Chandler
announced that it is “insolvency in fact” that triggers the existence of fiduciary duties to
creditors, not the threat or possibility of insolvency.
Moreover, “vicinity”, being presumably somewhere between solvency and
insolvency, creates practical difficulties in that it is not readily identifiable by
directors.327 The difficulty in satisfying the obligation may very-well cause managers to
be unaware that the corporation is in the vicinity of insolvency or has crossed the
threshold and entered the realm of insolvency.
Credit Lyonnais proposes that when in the vicinity of insolvency, directors owe a
duty not to a single constituency but to the corporation’s community of interests.328 At
the same time the Court fails to instruct us as to the breadth of the “community” that
directors need to consider. Commentators propose that while Chancellor Allen may have
failed to specify the constituencies that might belong to this community of interests,
perhaps what had in mind was the list of stakeholders described in Unocal Corp. v. Mesa
Petroleum Co.329 whose interests can be considered when a takeover is threatened.330
Another amorphous element of the court’s decision in Credit Lyonnais, is the
announcement that the objective of the directors in such instances is to maximize the
326
Geyer, 621 A.2d 784.
Thomson, supra note 294, at 44 (“[I]t will be difficult for them to identify the point at which
their duties to creditors switch from contractual to fiduciary in nature.”).
328
See Credit Lyonnais, 1991 Del. Ch. LEXIS at *109.
329
493 A.2d 946, 955 (1985).
330
See Thomson, supra note 294, at 44 (in the context of hostile takeovers. In Unocal, 493 A.2d at
955, the court upheld a directorial decision to consider other constituencies when facing a hostile takeover:
creditors, customers, employees, and the community. There would be no duty, however, to consider other
constituencies when a takeover is inevitable. In such circumstances, the duty can be discharged by
327
87
firm’s wealth creating capacity.331 To begin with, the meaning of the word “wealth” is
not self-evident332 and neither is the extent to which the firm’s capital structure is to be
incorporated in measuring wealth.333 Other critics point to further uncertainties
surrounding the Credit Lyonnais decision with respect to the application of the business
judgment rule,334 potential conflicts with previous case law,335 and procedural difficulties
in enforcing the standard.336
obtaining a maximum share price for the tendering shareholders. See Revlon, Inc. v. MacAndrews &
Forbes Holdings, Inc., 506 A.2d 173, 179 (1986).
331
See Credit Lyonnais, 1991 Del. Ch. LEXIS at *109.
332
Barondes, supra note 9, at 72. See also id. at 73-74:
[E]ven if “wealth” references profits determined in accordance with
Generally Accepted Accounting Principles (“GAAP”), consistently applied, a
court frequently would be unable independently to assess whether a particular
decision made by directors maximized “wealth.” The ambiguity as to the
definition of “wealth” thus creates additional uncertainty.
333
See id. at 74:
Even more problematic is the test’s ambiguity regarding the extent to which
the firm’s capital structure is incorporated in the wealth assessment. That is,
the opinion does not resolve the level of abstraction at which the “wealth
creating capacity” is judged. A firm’s capital structure may affect its ability
to pursue various strategies. Access to capital may require incurring
transaction costs that vary depending on the firm’s current capital structure.
334
See Nicholson, supra note 31, at 589:
[The business judgment rule] was not an issue [in Credit Lyonnais] because
Chancellor Allen found the executive committee’s actions to be highly
prudent and reasonable under the circumstances . . . . . It must be conceded,
however, that nothing in the opinion precludes the rule' s use and given its
availability in other reviews of director actions it would presumably also be
available here.
On the business judgment rule see generally Revlon, 506 A.2d at 180 and Aronson v. Lewis, 473
A.2d 805, 812 (Del. 1984) (the business judgment rule is a legal presumption that is afforded to the
directors of a corporation that in making a business decision the directors acted on an informed basis, in
good faith and in the honest belief that the action taken was in the best interests of the company).
335
In Revlon, the Delaware Supreme Court stated, “[a] board may have regard for various
constituencies in discharging its responsibilities, provided there are rationally related benefits accruing
to the stockholders.” [emphasis added]. Revlon, 506 A.2d at 182-84. Brent Nicholson proposes that,
Arguably, in Credit Lyonnais, there are no “rationally related benefits
accruing to the stockholders” from the directors’ actions. Revlon, on one
hand, may be distinguished because it involves a solvent corporation
88
In Israel, numerous legal scholars considered the issue of directors’ duties to
creditors.337 The general accord is that while it remains uncertain whether, and to what
extent, directors owe a duty to creditors while the corporation is solvent,338 it is clear that
a special duty exists once the corporation enters insolvency.339
The new Companies Law establishes a unique exception to the general rule,
which limits the right of creditors to initiate judicial proceedings, to situations of
liquidation.340 The exception under section 204 of the Companies Law affords the
undergoing a hostile takeover. On the other hand, the opinion rejects an
attempt to protect noteholders at the expense of shareholders.
See Nicholson, supra note 31, at 590.
336
Nicholson, supra note 31, at 590; Barondes, supra note 9, at 66:
Credit Lyonnais did not clearly address whether the duties articulated in the
case are affirmatively enforceable by creditors, i.e., whether creditors of a
distressed corporation can bring a lawsuit against the directors for pursuing
business strategies that do not promote the firm’s long-term wealth creating
capacity. The case could be read as merely granting directors of distressed
corporations an additional basis on which they could defend against lawsuits
filed on behalf of disgruntled shareholders.
337
Yechiel Bahat, Tachlit Ha’hevra Umatroteya Behatza’at Hok Hahavarot, 1995 [The Purpose
and Objectives of the Company in the Companies Bill, 1995], A(3) SHA’AREI MISHPAT 277, 299-303 (June
1998) (hereinafter Bahat, The Purpose and Objectives of the Company); YECHIEL BAHAT, THE LAW OF
CORPORATE CONVALESCENCE 64-65 (2d ed. 1991); Uriel Procaccia, Haba’alut Al Hafirma Vesyageyah:
Noshim, Ovdim, Almanot Veyetomim Bedinei Hahavarot [Firm Ownership and Its Margins: Creditors,
Employees, Widows and Orphans in Corporate Law], 22 MISHPATIM, 301, 308-312 (1993); Zipora Cohen,
Hovat Hazehirut Shel Hadirector Bahevra Hareshuma [Duty of Care of Directors in Registered
Companies], 1 MEHKAREI MISHPAT, 173 (1980).
338
See Bahat, The Purpose and Objectives of the Company, supra note 337, at 299 (the rights
arising from the contractual relationship between the creditors and the corporation is not enough to give
rise to a special duty to consider the creditors’ interests in the management of the enterprise).
339
Id. (the duty to consider the creditors’ interest is clear, at least with respect to insolvent
corporations); Zipora Cohen, Directors’ Negligence Liability to Creditors: A Comparative and Critical View,
26 IOWA J. CORP. L. 351, 355 (2001) (hereinafter Cohen, Directors’ Negligence Liability to Creditors):
A creditor cannot be allowed to intervene in matters connected with the
conduct of the corporation’s business, so long as the corporation meets its
obligations toward him. If the corporation becomes insolvent, there is
justification for enabling the creditor to bring an action against the directors
in respect to the manner in which they conduct the business of the
corporation, which has led to his inability to be repaid by the corporation.
340
This rule is generally applicable in Delaware.
89
creditors the right to bring a derivative action against the directors for unlawful
distributions.341 Delaware, in contrast, grants standing only to creditors of corporations
that are at the stage of insolvency or dissolution.342
However, whether or not this exception, standing alone, confers fiduciary duties
on the directors is not self-evident. Bahat identifies a general duty to creditors in sections
274, 308 and 309 of the Companies Ordinance, 1983, vis-à-vis provisions discussing
creditors’ meetings and the requirement to consider their stand. Gross identifies a general
duty by directors to consider the position of major creditors, as a prerequisite to the
application of the business judgment rule presumptions, when directors consider the
ability of the corporation to meet its obligations.343
Zipora Cohen concludes that the directors are not liable to creditors “even when
the law enables a corporate officer to take into account the benefit to the creditors”.344
Cohen relies on the recently introduced section 11 of the Companies Law345 to suggest
that while the provision does empower the directors to consider the interests of various
constituencies, including those of the creditors, shareholders, employees, and, perhaps,
341
342
The Companies Law, 1999, 204, S.H. 189.
DEL. CODE ANN. tit. 8 § 174(a) (2001):
[T]he directors . . . shall be jointly and severally liable, at any time within 6
years after paying such unlawful dividend or after such unlawful stock
purchase or redemption, to the corporation, and to its creditors in the event of
its dissolution or insolvency, to the full amount of the dividend unlawfully
paid, or to the full amount unlawfully paid for the purchase or redemption of
the corporation’s stock, with interest from the time such liability accrued.
343
GROSS, supra note 40, at 345 (to enjoy the presumptions of the business judgment rule
management will have to show, that in making the decision, they have duly considered the financial
disposition of the corporation, the long and short term objectives of the corporation, the advise of financial
advisers, and most importantly, the affect it would have on the creditors). See also The Companies Law,
1999, 302 S.H. 189.
344
Cohen, Directors’ Negligence Liability to Creditors, supra note 339, at 355.
345
The Companies Law, 1999, 11, S.H. 189.
90
even the public at large, the provision does not entitle them to bring an action on the
grounds that their interests were not weighed properly.346
Israeli legal scholars further raise the possibility that directors owe creditors
fiduciary duties when the corporation is near insolvency.347 Israeli courts may wish to reexamine Delaware’s approach on this issue in the aftermath of Credit Lyonnais. Royce
Barondes proposes, that in the aftermath of Credit Lyonnais, creditors may have the right
to bring a cause of action against directors by alleging that the directors failed to promote
the creditors’ interests when the corporation was nearly insolvent.348 He writes,
Credit Lyonnais may be read as creating an obligation to
stakeholders who are not shareholders that those stakeholders
can enforce. In the alternative, Credit Lyonnais may merely be
permissive--it may permit directors of nearly insolvent
corporations to consider interests whose consideration otherwise
would be improper under otherwise applicable fiduciary duty of
loyalty requirements.349
Israeli academics further make references to English common law on the subject
that, while is not a controlling precedent, is regarded as laying the groundwork for
acknowledging such a duty in Israeli law.
Bahat argues, that the body of English case law supports the proposition that a
duty to creditors indeed subsists, though its extent is controversial.350 For instance, in
346
Cohen, Directors’ Negligence Liability to Creditors, supra note 339, at 355.
Bahat, The Purpose and Objectives of the Company, supra note 337, at 299 (at the point of
insolvency, and perhaps near insolvency, the corporation has a general duty, intertwined with that owed to
the creditors, to maintain profits, diminish losses, and contemplate risks as central objectives in the survival
of the corporation).
348
Barondes, supra note 9, at 71. See also id. at 69-70 (Delaware case law subsequent Credit
Lyonnais).
349
Id. at 69.
350
See Lornho Ltd. v. Shell Petroleum Co. Ltd. [1980] 1 W.L.R. 627, 634; Rolled Steel Products
(Holding) Ltd. v. British Steel Corp [1985]; Re Horsley & Weight Ltd. [1982] 3 All E.R. 1045;
Multinational Gas & Petrochemical Co. Ltd. v. Multinational Gas & Petrochemical Co. Services Ltd.
[1983] Ch. 258, 288; [1983] 3 W.L.R. 492, 519 (C.A.).
347
91
Kinsella v. Russell Kinsella Pty. Ltd. (In Liq) (1986),351 Street C.J. held that though
shareholder interests hold primacy in the context of a solvent corporation, once the
corporation is insolvent then the interests of the creditors intrude,
They become prospectively entitled, through the mechanism of
liquidation, to displace the power of the shareholders and
directors to deal with the company’s assets. It is in a practical
sense their assets and not the shareholders’ assets that, though
the medium of the company, are under the management of the
directors pending either liquidation, return to solvency, or the
imposition of some alternative administration.352
This holding appears to suggest that insolvency triggers the onus of fiduciary
duties to creditors, in substitution of the shareholders that were previously the
corporation’s qua beneficiaries.353 However, further in his opinion Street C.J. clarifies
that, “the directors’ duty to a company as a whole [merely] extends in an insolvency
context to not prejudicing the interests of creditors”, as opposed to substituting the
beneficiaries.354
Davis Thomson, an English scholar, asserts that these remarks indicate that,
“rather than triggering the wholesale substitution of the body of creditors for the body of
shareholders, insolvency alters the relative weight that directors should give to
shareholder interests as opposed to creditor interests.”355 Thomson argues that, at all
times, the directors’ fiduciary duty is owed to the company and no separate duty to
creditors exists.
351
4 N.S. W.L.R. 722.
Kinsella, 4 N.S. W.L.R. 722, 730.
353
Thomson, supra note 294, at 39.
354
Kinsella, 4 N.S.W.L.R. 722, 732.
355
Thomson, supra note 294, at 40.
352
92
In another British case, In Re Horsley & Weight Ltd.,356 Buckley L.J. for the court
stated,
[I]t is a misapprehension to suppose that the directors of a
company owe a duty to the company’s creditors to keep the
contributed capital of the company intact . . . . It may be
somewhat loosely said that the directors owe an indirect duty to
the creditors not to permit any unlawful reduction of capital to
occur, but I would regard it as more accurate to say that the
directors owe a duty to the company in this respect.357
Templeman L.J. (concurring) further stated, “if the company had been doubtfully
solvent at the date of the grant to the knowledge of the directors, the grant would have
been both a misfeasance and a fraud on the creditors for which the directors would
remain liable.”358
Thomson359 and Bahat360 read these statements as suggesting that when the
corporation enters insolvency or is at the verge of insolvency, directors could owe a duty
directly to creditors.
Lord Templeman, however, had the opportunity to later clarify his position in
Winkworth v. Edward Baron Development Co. Ltd, (1987)361 (a unanimous decision of
the House of Lords) stating,362
[A] company owes a duty to its creditors, present and future.
The company is not bound to pay off every debt as soon as it is
incurred and the company is not obligated to avoid all ventures
which involve an element of risk, but the company owes a duty
to its creditors to keep its property inviolate and available for the
repayment of its debts. The conscience of the company, as well
as its management, is confided to its directors. A duty is owed
356
[1982] 3 W.L.R. 431.
Horsley, 3 W.L.R. 431 at 442.
358
Id. at 443.
359
Thomson, supra note 294, at 42.
360
Bahat, The Purpose and Objectives of the Company, supra note 337, at 301 n.99.
361
1 All E.R. 114.
362
Id. at 118.
357
93
by the directors to the company and to the creditors of the
company to ensure that the affairs of the company are properly
administered and that its property is not dissipated or exploited
for the benefit of the directors themselves to the prejudice of the
creditors.
Thomson interprets Lord Templeman’s statement to mean that directors owe
some form of duty to creditors that parallels the duty owed to the company. This duty
arises, per Thomson, regardless of whether the company is solvent or insolvent.363
However, Thomson emphasizes that nowhere in Lord Templeman’s statement does he
explicitly state that the duty is fiduciary in nature.364 Thomson interprets Lord
Templeman’s decision to say that the duty owed by directors to creditors is, merely, “an
extension of the contractual duty owed by the company to creditors, not an extension of
the fiduciary duty owed by directors to the company” and as such, would arise apart from
insolvency.365
Hence far, Thomson concludes that the general position under U.K. law is that,
“directors do not owe a fiduciary duty directly to creditors.” The directors owe a
fiduciary duty only to the corporation. However, the company enters into a state of
insolvency, “the duty to the corporation must be exercised in a manner that does not
disregard or prejudice the interests of creditors.”
363
Thomson, supra note 294, at 42.
See id.
365
See id.; Kuwait Asia Bank EC v. National Mutual Life Nominees Ltd. [1990] 3 All E.R. 404
(Lord Templeman concurring) (clarifying that a fiduciary relationship does not normally exist between
directors and creditors. Directors may owe a duty to creditors that is contractual in nature or a duty will be
implied where the creditor relies upon a certain representation. However, such duties are independent and
different from the fiduciary duty that the directors owe the corporation, and would arise regardless of
whether or not the company became insolvent); West Mercia Safetywear Ltd. (Liq.) v. Dodd [1988] P.C.C.
212, 215 (the Court of Appeal held that a director “was guilty of a breach of duty when, for his own
purposes, he caused £ 4,000 to be transferred in disregard for the interests of the general creditors of [an]
insolvent corporation.” The Court distinguished its decision from an earlier ruling (Multinational Gas v.
Multinational Services [1983] Ch. 258 at 288 (C.A.)), where it held, that directors do not owe fiduciary
duties to the creditors of a solvent corporation).
364
94
Though English common law may have historically been the predominant thrust
in the development of Israeli jurisprudence, it has since taken on a personality of its own.
With respect to fiduciary duties, for one, the Supreme Court of Israel and legal writers
repeatedly demonstrate an open-minded approach to views expressed by American
courts.
Bahat interprets the aforementioned English precedents, as leaving an open door
on the scope of the duties owed by directors to corporate creditors.366 Furthermore, the
Supreme Court has recently stated, obiter dicta though, that the shareholders of an Israeli
corporation may handle corporate assets as they see fit, provided that third party interests,
such as creditors’ interest, are not implicated.367
Therefore, with English precedent on its heels and, perhaps, American law in the
horizon the future of directors’ liability to creditors remains open.
ii.
Improprieties Of Share Repurchase
Delaware law recognizes that the position of creditors (and shareholders) might
be prejudiced in the event of a repurchase.368 Therefore, Delaware courts require directors
to employ utmost good faith and good judgment before carrying out repurchase plans369
and does not afford them the automatic presumption of the business judgment rule.370
366
367
Bahat, The Purpose and Objectives of the Company, supra note 337, at 301.
C.A. 995/90 Adoram Engineers Ltd. v. Hanna Gat & Others, TAKDIN ELYON 92(2), 2378 (S.
Ct. Isr.).
368
See DEL. CODE ANN. tit. 8 § 160 statutory notes (2001), Propp v. Sadacca, 40 Del. Ch. 113,
175 A.2d 33 (1961) modified 41 Del. Ch. 14, 187 A.2d 405 (1962). See also City Capital Assocs. v.
Interco, Inc., 551 A.2d 787, 796 (Del. Ch. 1988) (“Unocal recognizes that human nature may incline even
when acting in subjective good faith to rationalize as right that which is merely personally beneficial.”).
369
Id.
370
DEL. CODE ANN. tit. 8 § 160 statutory notes (2001).
95
Directors of a Delaware corporation owe fiduciary duties of loyalty371 and of
care372 to both the corporation and its stockholders.373 Traditionally, the business
judgment rule affords the directors with a legal presumption that in making a business
decision, the directors acted on an informed basis, in good faith, and in the honest belief
that the action taken was in the best interests of the company.374 Looking at both the
procedural propriety of the decision375 and the decision itself, the court will not substitute
their business judgment for that of the board if the board’s decision, “can be attributed to
any rational business purpose.”376
Israeli draftsmen acknowledge too, that in certain circumstances, particularly
where the corporation is not lucrative, the shareholders and/or the directors may attempt
to export the remaining assets for their benefit, to avoid having to pay them to the
371
“[The duty of loyalty] instructs directors to be absolutely fair and candid in pursuing personal
interests. Thus, it makes it wrongful for a director unfairly to compete with her corporation or unfairly to
divert corporate resources or opportunities to her personal use.” O’KELLEY & THOMPSON, supra note 7, at
259; AC Acquisitions Corp. v. Anderson, Clayton & Co., 519 A.2d 103, 111 (Del. Ch. 1986) (The
plaintiffs can demonstrate that the directors breached their duty of loyalty by showing that they engaged in
self-dealing) (courts will not “evaluate the merits or wisdom of the transaction once it is shown that the
decision . . . was made by directors with no financial interest in the transaction adverse to the corporation
and that in reaching the decision the directors followed an appropriately deliberative process.”).
372
Rifkind, supra note 222, at 112-15,
The duty of care is an obligation to act on an informed basis after due
consideration of all relevant materials, including advice from legal and
financial experts, and appropriate deliberation. A plaintiff can demonstrate a
director’s breach of duty of care by proving that the director’s acts rise to the
level of gross negligence.
And see id. at 120 n.91, citing Aronson, 473 A.2d at 812 (“While the Delaware cases use a variety
of terms to describe the applicable standard of care, our analysis satisfies us that under the business
judgment rule director liability is predicated upon concepts of gross negligence.”).
373
See Mills Acquisition Co. v. MacMillan, Inc., 559 A.2d 1261, 1280 (Del. 1988) (describing the
board’s fiduciary duties to the shareholders); Revlon, Inc. v. MacAndrews &Forbes Holding, 506 A.2d
173, 179 (Del. 1986).
374
See Revlon, 506 A.2d at 180 and Aronson, 473 A.2d at 812.
375
Plaintiff bears the burden of showing the defects in the directors’ decision-making process. See
Unitrin, 651 A.2d at 1374 (“When the business judgment rule is applied . . . the plaintiff has the initial
burden of proof and the ultimate burden of persuasion.”).
376
Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971).
96
creditors.377 By operation of law Israeli courts examine reacquisition of stock under the
umbrella of distributions,378 and focus their attention on ascertaining whether the purpose
of the acquisition was a proper or an improper. An attempt to dilute corporate assets for
the personal benefit of the directors and/or a controlling shareholder will be struck
down.379
Israeli law imposes on the directors (and other executives) duties of care and of
loyalty.380 In contrast to Delaware, however, Israel treats a decision to reacquire
corporate shares as any other business decision. As such, management is afforded the
presumptions of the business judgment rule,381 and its decisions upheld, whenever it can
shown that the challenged decisions fell within management’s authority, and were made
on an informed basis, in good faith, and in the honest belief that they serve the best
interests of the corporation.382 An informed decision will be one that duly considers the
financial disposition of the corporation and its long and short term objectives, as well as,
the advise of financial advisers, and, most importantly, the effect it would have on the
creditors.383
Thus, in general, Delaware and Israeli courts will not interfere with a decision to
adopt a stock repurchase plan, absent of a showing that the shares have been caused to be
purchased for an improper purpose.384 Courts are likely to look extra close, however, at
377
BAHAT, supra note 47, at 444-45.
See discussion infra p. 30.
379
BAHAT, supra note 47, at 444-45.
380
GROSS, supra note 40, at 345.
381
See id.
382
See id. See also ABRAHAM PELMAN, DINEI HAVAROT BE’ISRAEL HALACHA LEMA’ASE
[Corporations Law in Israel Concept and Operation] 615 (Hadara Bar-Mor ed., 4th ed. 1994).
383
GROSS, supra note 40, at 345.
384
DEL. CODE ANN. tit. 8 § 160 statutory notes (2001), citing Alcott v. Hyman, 40 Del. Ch. 449,
184 A.2d 90 (1962), aff’d, 42 Del. Ch. 233, 208 A.2d 501 (1965). See also Crane Co. v. Harsco Corp., 511
F. Supp. 294 (D. Del. 1981); GROSS, supra note 40, at p.345.
378
97
repurchase plans that appear to benefit the insiders unduly, and that appear to be clear
self-dealing.
It is further submitted that in the context of share repurchases aggravated by a
takeover threat, the business judgment rule does not apply automatically to the conduct of
Delaware directors.385
Israeli courts have not had the opportunity to consider the application of the
business judgment rule in this specific context (considering that buybacks are somewhat
of a novelty to Israeli law). Currently, there are no requirements that a repurchase be
made equally from each shareholder, nor that corporations announce a private repurchase
from all shareholders.386
Apparently, until Israeli courts examine buyback in the unique context of takeover
threats, the presumption of the business judgment rule will continue to apply just as it
does to other managerial decisions. Nonetheless, it is most likely that Israeli courts will
consider customizing U.S. methodology on the subject.
Delaware courts have long recognized a potential conflict of interest whenever
directors are acting in defense of a hostile takeover.387 It has become generally accepted,
that when introducing anti-takeover defensive measures, target management and the
board of directors might be more easily drawn to make decisions based on personal
agendas rather than shareholders’ welfare. Thus, with respect to challenged anti-takeover
385
See Unitrin, 651 A.2d at 1372 citing Pogostin v. Rice, 480 A.2d 619 (Del. Super. Ct. 1984).
GROSS, supra note 40, at 338.
387
In Bennett v. Propp, for instance, the court acknowledged that it “must bear in mind the
inherent danger in the purchase of shares with corporate funds to remove a threat to corporate policy when
a threat to control is involved.” The court emphasized that “[t]he directors are of necessity confronted with
a conflict of interest, and an objective decision is difficult.” Bennett v. Propp, 187 A.2d 405 (Del. 1962).
386
98
tactics, management must satisfy a two-part enhanced scrutiny test before it may enjoy
the presumptions of the business judgment rule,
Because of the omnipresent specter that a board may be acting
primarily in its own interests, rather than those of the
corporation and its shareholders, there is an enhanced duty
which calls for judicial examination at the threshold before the
protections of the business judgment rule may be conferred.
Unocal Corp. v. Mesa Petroleum Co. (citation omitted).
Unocal’s enhanced scrutiny raises the standard of review over managerial
decisions, from a rational basis review to a standard of reasonableness.388 To survive the
enhanced scrutiny test, directors must show389 that, “they had reasonable grounds for
believing that a danger to corporate policy and effectiveness existed”,390 and that the
board action taken in response was “reasonable in relation to the threat posed.”391
Management, or the board, could satisfy the burden (and thus be afforded the protections
of the business judgment rule) by showing “good faith and reasonable investigation”.392
388
Rifkind, supra note 222, at 121.
The burden of proof is placed on the directors. Id. (“Unlike the business judgment rule, which
puts the burden of proof on the plaintiff, the Unocal test shifts the burden of proof to the directors.”);
Paramount, 637 A.2d at 45 (“The directors have the burden of proving that they were adequately informed
and acted reasonably.”); DEL. CODE ANN. tit. 8 § 160 statutory notes (2001) (“Where the use of corporate
funds to purchase corporate shares will maintain management in control, the burden is on the directors to
justify the purchase as one primarily in the corporate interest and not their own. Petty v. Penntech Papers,
Inc.(citation omitted).”).
390
This test is known as the “reasonableness test”. See Unocal, 493 A.2d 946, restated in Unitrin,
651 A.2d at 1385-85:
389
[A] court applying enhanced judicial scrutiny should be deciding whether the
directors made a reasonable decision, not a perfect decision. If a board
selected one of several reasonable alternatives, a court should not second
guess that choice even though it might have decided otherwise or subsequent
events may have cast doubt on the board’s determination. Thus, courts will
not substitute their business judgment for that of the directors, but will
determine if the directors’ decision was, on balance, within a range of
reasonableness.
391
This test is known as the “proportionality test”. See Unocal, 493 A.2d at 955. And see Unocal,
493 A.2d 946 restated in Unitrin, 651 A.2d at 1373.
392
Unocal, 493 A.2d at 955, quoting Cheff v. Mathes, 199 A.2d 548, 554-55 (Del. 1964)). And see
Rifkind, supra note 222, at 121 (“A majority of outside directors on the board ‘materially enhance[s]’ a
showing of good faith and reasonable investigation.”).
99
Thus, a decision of a board of directors, comprised of a majority of disinterested
and independent directors, which was taken subsequent to considerable investigation
would establish a presumption that the business judgment rule applies,
In the face of this inherent conflict directors must show that they
had reasonable grounds for believing that a danger to corporate
policy and effectiveness existed because of another person’s
stock ownership. Cheff v. Mathes (citation omitted). However,
they satisfy that burden “by showing good faith and reasonable
investigation. . . .” (citation omitted). Furthermore, such proof is
materially enhanced, as here, by the approval of a board
comprised of a majority of outside independent directors who
have acted in accordance with the foregoing standards. See
Aronson v. Lewis, (citation omitted); Puma v. Marriott, (citation
omitted); Panter v. Marshall Field & Co., (citation omitted).393
Clearly, insiders may not use defensive measures merely to perpetuate themselves
into power,394 but must have acted out of good-faith intention to protect the corporation.
Perceived threats that the court will consider would include threats to corporate policy,395
as well as threats posed by a stockholder at odds with management.396 Accordingly, a
393
Unocal, 493 A.2d at 955.
See DEL. CODE ANN. tit. 8 § 160 statutory notes (2001) (citing Cheff, 199 A.2d at 554 (1964))
(“if the board has acted solely or primarily because of the desire to perpetuate themselves in office, the use
of corporate funds for such purposes is improper.”). See also id. Petty v. Penntech Papers, Inc., Del. Ch.,
347 A.2d 140 (1975), and Crane Co. v. Harsco Corp., 511 F. Supp. 294 (D. Del. 1981) (“The use of
corporate funds to perpetuate control of the corporation is improper, and the burden should be on the
directors to justify a stock purchase as one primarily in the corporate interest.”).
395
DEL. CODE ANN. tit. 8 § 160 statutory notes (2001):
394
If the purchase of its own stock by the board was motivated by a sincere
belief that the buying out of the dissident stockholder was necessary to
maintain what the board believed to be proper business practices, the board
will not be held liable for such decision, even though hindsight indicates the
decision was not the wisest course. Cheff v. Mathes (citation omitted).
...
Using corporate funds to purchase corporate stock in order to remove a
threat to corporate policy is proper. Unocal Corp. v. Mesa Petro. Co.(citation
omitted); Polk v. Good (citation omitted).
396
DEL. CODE ANN. tit. 8 § 160 statutory notes (2001):
A reduction of capital through the purchase of shares at private sale is not
illegal as a matter of law simply because the purpose or motive of the
100
stock repurchase motivated by a reasonable belief that the bidder, if successful, will
change the business practices of the corporation to the detriment of the corporation’s
ongoing business and existence, is likely to be upheld. A change reasonably likely to
cause harm to the corporation could be a bidder’s plan to bust up and liquidate the
corporation, or to operate the corporation in an illegal or unethical manner, or that
valuable corporate assets might be lost as a result of the bidder coming into control.397
In Unitrin, Inc. v. American General Corp.,398 Delaware’s Supreme Court
reviewed a board’s decision to adopt a share repurchase program (in addition to a poison
pill rights plan) launched as an attempt to repel an unwanted tender offer. In the course of
upholding the board’s conduct, the court restated the general rule laid down by Unocal,
and redefined the proportionality aspect of that test.399 The court broke down Unocal's
proportionality requirement into a two-part test. First, requiring a determination of
whether the challenged defensive action was “draconian”, such that precluded or coerced
shareholder choice, and second, if the decision was not draconian, the court would
inquire into whether the board’s response fell within the range of reasonableness.400
In considering the second requirement, that the defensive measure be a response
that is reasonable in relation to the threat posed, we draw from Unitrin’s restatement that
purchase is to eliminate a substantial number of shares held by a stockholder
at odds with management policy, provided of course that the transaction is
clear of any fraud or unfairness. Kors v. Carey (citation omitted).
The statutory power granted to corporations to purchase shares of their
own stock is subject to abuse, but a thoughtful and honest decision of the
board of directors to buy out a stockholder who threatens actual harm to his
corporation may be sustained. Propp v. Sadacca (citation omitted).
397
E.g., valuable corporate contracts that are non-assignable, like special licenses.
651 A.2d 1361 (Del. 1995).
399
Id. at 1385-91.
400
Id. at 1387-88.
398
101
the measure be neither “coercive” nor “preclusive”.401 A defensive action is preclusive,
if it prevents stockholders from considering a particular transaction,402 if it deprives the
stockholders of their rights to receive tender offers, or fundamentally restricts proxy
contests.403 Secondly, according to Unocal’s enhanced business judgment, Delaware
401
Id.:
As common law applications of Unocal’s proportionality standard have
evolved, at least two characteristics of draconian defensive measures taken by
a board of directors in responding to a threat have been brought into focus
through enhanced judicial scrutiny. In the modern takeover lexicon, it is now
clear that since Unocal, this Court has consistently recognized that defensive
measures which are either preclusive or coercive are included within the
common law definition of draconian. If a defensive measure is not draconian,
however, because it is not either coercive or preclusive, the Unocal
proportionality test requires the focus of enhanced judicial scrutiny to shift to
“the range of reasonableness.” Paramount Communications, Inc. v. QVC
Network, Inc. (citation omitted). Proper and proportionate defensive
responses are intended and permitted to thwart perceived threats.
402
A “preclusive” measure would be one that would frustrate a hostile bid, notwithstanding what
the bidder offers. For example, a preclusive poison pill is a repurchase plan, which guarantees the right of
each shareholder, but not that of the bidder, to sell back her shares to the corporation at a considerably
higher value than their fair market value. Alternatively, the poison pill plan may stipulate the acquisition of
the bidder’s company shares at a fraction of their fair market value. Delaware courts have had the
opportunity to set some baseline principles on identifying preclusive measures. In Paramount, the court
held that Time’s restructured merger with Warner constituted a proportionate response because it did not
preclude Paramount from making an offer for the combined company, thus, making the response
proportionate. See Paramount, 571 A.2d at 1155. Furthermore, in City Capital Associates v. Interco, Inc.,
551 A.2d 787, 797 (Del. Ch. 1988), Delaware’s Court of Chancery defined “preclusive” as an, “action that,
as a practical matter, withdraws from the shareholders the option to choose between the offer and the status
quo or some other board sponsored alternative.” The Court held that Interco’s poison pill was
disproportionate and preclusive because it deprived shareholder the right to choose between the tender offer
and a management’s restructuring program. Id. at 799.
403
For instance, in Moran v. Household International, Inc., 500 A.2d 1346, 1357 (Del. 1985) the
court held that the poison pill adopted in response to a speculative threat of a hostile takeover was
proportionate because it did not strip stockholders of their rights to receive tender offers (because the pill
was redeemable upon the directors’ decision, and such decision would be subject to scrutiny. id. at 1354) or
fundamentally restrict proxy contests. According to the Unitrin panel, a proxy contest remains a viable
alternative, unless “success would be either mathematically impossible or realistically unattainable.” See
Unitrin, 651 A.2d at 1388-89. Later that year, the District Court of Delaware in Moore Corp. v. Wallace
Computer Servs., Inc., 907 F. Supp. 1545, 1561 (D. Del. 1995) upheld a decision to keep a poison pill in
place because doing so would not prevent a proxy contest from succeeding. And see Mark Lebovitch &
Peter B. Morrison, Calling A Duck A Duck: Determining The Validity Of Deal Protection Provisions In
Merger of Equals Transactions, 2001 COLUM. BUS. L. REV. 1, 45 (2001):
For example, when a board adopts a no-talk provision, it prevents itself from
communicating with other potential bidders for the company. In doing so, the
board makes it less likely that alternative bidders will come forward, thereby
reducing the possibility that the stockholders will have alternative deals on
102
courts will enjoin defensive measures also if they are “coercive”. A defensive act is
coercive if it is aimed at “cramming down” on the shareholders a managementsponsored alternative,404 leaving shareholders with no rational choice but to accept the
alternative presented by the board.405
Mark Lebovitch and Peter Morrison provide a useful example of a coercive
action in the context of deal protection provisions,406
[A] coercive Deal Protection may tend to force or compel
stockholders to vote for a particular transaction. For example,
when a board agrees to an extremely high termination fee tied
to a “no” vote, it agrees to pay its merger partner a fixed fee,
typically a percentage of the original negotiated deal, if the
corporation’s stockholders reject the transaction. This device
is directly coercive of the stockholder vote because the
stockholders know that if they vote against the negotiated
transaction, their corporation will automatically be
responsible for paying the potential merger partner a
significant sum of money. Because they want to avoid the
which to vote. Depending on the facts of the case, that Deal Protection may
be struck as overly preclusive.
404
Unitrin, 651 A.2d at 1387:
In Time, for example, this Court concluded that the Time board’s defensive
response was reasonable and proportionate since it was not aimed at
‘cramming down’ on its shareholders a management-sponsored alternative,
i.e., was not coercive, and because it did not preclude Paramount from
making an offer for the combined Time-Warner company, i.e., was not
preclusive. See Paramount Communications, Inc. v. Time, inc.(citation
omitted) (citing for comparison as coercive or preclusive disproportionate
responses Mills Acquisition Co. v. Macmillan, Inc. (citation omitted), and
AC Acquisitions Corp. v. Anderson, Clayton & Co. (citation omitted).
[emphasis added]
405
See Unitrin, 651 A.2d at 1387. For instance, where management response amounts to a waste
of corporate assets, either as part of a greenmail transaction coupled with a standstill agreement, or by
selling attractive assets at low prices to reduce the attractiveness of the corporation, but at the same time
causing irreversible damage to the corporation itself.
406
Deal protection provisions are contractual provisions, designed to raise the likelihood of
completion of first-negotiated deals by making the successful acceptance of a competing bid less likely.
Such provisions may include, for example, no-talk, no-shop, required recommendation and/or presentation
for vote, termination fee, no termination until a preset date, and cross-option provisions. See Lebovitch
&Morrison, supra note 403.
103
significant pay-out, they may tend to vote for the transaction,
even if they are not completely satisfied with the deal.407
Similarly, “dead hand”408 and “no hand”409 provisions in poison pill plans
have come under scrutiny for confining the board from redeeming or amending the
shareholder rights plan.410 Such provisions will further have to survive scrutiny
under the fiduciary duty standards of Unocal411 and Blasius Industries v. Atlas
Corp.412
It is yet to be seen, whether, and to what extent, Israeli courts tackle
defensive share repurchases as a distinctive phenomenon. Unocal’s enhanced
scrutiny standard is an intermediary level of review. It is considered to be, “stricter
than the business judgment rule and more deferential than the entire fairness
standard”.413 However, it is, “neither a mathematical formula nor an abstract theory,
but rather a flexible paradigm courts will apply to the myriad fact scenarios that
confront corporate boards.”414 As such, its implementation in Israeli case law should
be a daunting task.
407
Id. at 45.
Dead hand provisions classically take the form of limiting the ability of the continuing directors
(directors who were in office at the time the plan was adopted and successors whom they have approved) to
amend or redeem the shareholder rights plan. Even if a hostile bidder later becomes successful in replacing
a majority of the target’s board, the new board would still be unable to redeem or amend the pill for the
purpose of allowing the proposed acquisition to proceed.
409
No-hand provisions are a variation of the dead hand provisions. They have the effect of
delaying redemption plans, which might discourage prospective hostile bidders from entering the bidding
game.
410
See generally, Peter V. Letsou, Symposium, Contemporary Issues In the Law Of Business
Organizations: Are Dead hand (And No Hand) Poison Pills Really Dead?, 68 U. CIN. L. REV. 1101 (2000).
411
Poison pill provision cannot be “preclusive” or “coercive”. Unocal, 493 A.2d 946.
412
Poison pill provisions cannot purposely disenfranchise shareholders, absent a compelling
motive. Blasius Industries v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988).
413
Rifkind, supra note 222, at 121.
414
Id.
408
104
iii.
Selective Repurchases In Delaware
a.
Greenmail
The use of selective stock repurchases or greenmail415 to eliminate the interests of
a shareholder at odds with management, has continually been permitted by Delaware
courts.416 The first and leading Delaware case on the legal validity of greenmail, was
Cheff v. Mathes.417
In Cheff, a Delaware court found that selective stock repurchases, or greenmail,
were proper unless the directors had caused the corporation to repurchase the shares for
an improper purpose. The general rule emerging from Cheff was that Delaware courts
would uphold a transaction, which purpose was to avoid a hostile takeover, where the
directors reasonably believes that the hostile takeover could be damaging to the
corporation’s existence or to important aspects of its business. In such instances, the
payment of a premium in return for a standstill agreement (to prevent the hostile
takeover) would most likely be upheld, despite the fact that it effectively enriched the
bidder at the direct expense of the corporation and its shareholders.
In Cheff, the court upheld the payment of greenmail on the ground that the board
justifiably feared the hostile bidder’s poor reputation as a corporate raider, which had
threatened to liquidate the company or materially change its sales policies.418 The court
found that the directors had acted in good faith and upon reasonable investigation in
415
“Greenmail is a term that describes a corporation’s repurchase of its own stock from one or a
small number of shareholders at a premium above market price, thereby eliminating a raider’s potential bid
for the target corporation, or severing ties with a shareholder that poses a threat to the future policies of the
corporation.” Eric Bielawski, Note, Selective Stock Repurchases after Grobow: The Validity of Greenmail
under Delaware and Federal Securities Laws, 15 DEL. J. CORP. L. 95, 95 n.3 (1990).
416
Macey & McChesney, supra note 243, at 23.
417
199 A.2d 548 (Del. 1964).
418
Unocal, 493 A.2d at 957.
105
using corporate funds to buy out a dissident.419 Interestingly, the size of the greenmail
premium above the market value was not a key aspect in Cheff and in the cases that
followed, except, perhaps, that a very large premium might indicate that the board of
directors had been motivated primarily by self-interest.
The standard espoused in Cheff was later reaffirmed in Kaplan v. Goldsamt,420and
also endorsed, albeit in dicta, in Unocal.421 In Unocal, Mesa Petroleum acquired a large
minority block of stock in Unocal. Unocal responded by offering to purchase, at a
premium, all outstanding shares to the exclusion of the shares owned by Mesa. The
Supreme Court of Delaware upheld Unocal’s selective stock repurchases, and endorsed
its earlier holdings in Cheff and Kaplan.422
Hence, so far, in the context of hostile takeover defenses, Delaware courts have
approved the payment of greenmail as an available defense in thwarting a possible
takeover.423 It is notable, that while the initial burden lies on the board to satisfy Unocal’s
two-prong test, the analysis of the court in Polk v. Good424 appears to suggest that it will
be hard to invalidate a greenmail payment under the business judgment rule.425 In a nonhostile takeover climate,426 the burden is initially placed on the plaintiffs to plead for the
419
Cheff, 199 A.2d at 556.
380 A.2d 556 (Del. Ch. 1977). In Kaplan, the plaintiff (stockholder) argued that the corporation
paid greenmail in order to avoid a hostile proxy fight that could have led to a change in control. The court
stated that the use of greenmail was proper, provided that its purpose was, “to eliminate what appears to be
a clear threat to the future business or the existing, successful, business policy of a company.” id. at 569.
The court held, that the board’s decision to pay greenmail was protected by the business judgment rule
because in making the selective repurchase, the board’s sole purpose was not to perpetuate itself in control.
421
Unocal, 493 A.2d 946.
422
Id. at 957.
423
Polk, Del. Supr., 507 A.2d at 537.
424
Del. Supr., 507 A.2d 531 (1986).
425
Bielawski, supra note 415, at 132.
426
For instance, in the case of Grobow v. Perot, 539 A.2d 180 (Del. 1988), discussed hereafter, a
derivative suit was brought by the shareholders on behalf of General Motors (GM), challenging the
repurchase of GM’s stock from its largest shareholder H. Ross Perot, who was also a member of the GM
Board. The complaint alleged, inter alia, that the GM directors breached their fiduciary duties of loyalty
420
106
inapplicability of the business judgment rule.427 It is the plaintiff who is charged with the
burden of proving foul purpose or personal motives of the directors.428
b.
Exclusionary Repurchases
The two most common ways a corporation can deal selectively in its own stock,
are by repurchasing a substantial block of stock from a dissident shareholder, typically at
a large premium unavailable to the other shareholders, i.e. greenmail, or by engaging in
an exclusionary self-tender offer for the corporation’s shares.
A Delaware corporation may decide to conduct an exclusionary self-tender,
thereby offering to purchase its shares, usually at a price in excess of the bidder’s tender
price, in order to eliminate a takeover threat. In an exclusionary self-tender offer, a
corporation precludes a bidder, who is attempting a hostile takeover, from tendering his
shares into the offer.429
In this respect, Unocal430 presents a classic scenario, and the changes that
followed it, illustrate the viability of discriminatory self-tender offers as a defensive
tactic. In Unocal, Mesa, owning thirteen percent of Unocal’s outstanding stock, made a
two-tiered front-loaded tender offer for thirty-seven percent of Unocal’s outstanding
stock.431 The offer indicated that once in control of Unocal, Mesa would buy out the
remaining shareholders (through a back-end cash-out merger) using highly subordinated
and due care by paying greenmail, and that the repurchase lacked a valid business purpose. The complaint
further alleged that the board’s decision was primarily designed for the purpose of entrenching the board
members in office.
427
Id. at 189.
428
Bielawski, supra note 415, at 132.
429
See, e.g., Unocal, 493 A.2d at 951. Unocal adopted an exclusionary self-tender offer designed
to discourage a hostile bidder and preserve the corporation as a going concern.
430
Id.
431
Id. at 949. Mesa offered $54.00 per share in cash for the shares tendered in the first tier of its
offer.
107
securities, commonly called “junk bonds”.432 After deciding that Mesa’s tender offer
was “inadequate”, Unocal’s board of directors offered the shareholders an alternative
self tender,433 designed to ensure that shareholders who did not tender to Mesa at the
front end of the tender offer, would be adequately compensated at the back end of the
offer. The board offered to have Unocal repurchase up to forty-nine percent of its
shares in exchange for debt securities,434 in the event that Mesa succeeded with its
tender offer. Excluded from participating in this offer was Mesa.435 Mesa argued that in
excluding it from the tender offer, the board violated its fiduciary duty to it as a
shareholder.436
On these facts, the Supreme Court laid down the standard for examining
defensive tactics designed to thwart hostile takeovers. First, in applying Cheff’s
standard,437 the defendant directors carried the burden of demonstrating reasonable
grounds for believing that a danger to corporate policy and effectiveness existed. The
court held that showing good faith and reasonable investigation could satisfy the
burden.438 The second prong of the test, entailed examining the proportionality of the
defensive measure employed, in relation to the threat posed.439 The court stated that
such an analysis involves, “the examination of the type of takeover bid, the defensive
measure employed, and its effect on the corporate enterprise, including the impact on
432
Id. at 949-50. The junk bonds had an estimated value of $54.00 per share.
Id. at 950-51.
434
Id. at 951. The debt securities that were offered in exchange had an aggregate par value of
$72.00 per share.
435
Id.; Laura L. Cox, Comment, Poison Pills: Recent Developments in Delaware Law, 58 U. CIN.
L. REV. 611, 623 n.73 (1989) (“Including Mesa would have in effect forced Unocal to partially finance
Mesa’s tender offer.”).
436
Unocal, 493 A.2d at 953, 957.
437
Id. at 955.
438
Id.
439
Id.
433
108
constituents other than the shareholder.”440 The court upheld the share repurchase
program, including its exclusion of Mesa, finding that the directors satisfied the burden of
showing reasonable ground to believe that Mesa’s actions posed a threat on the
corporation’s welfare (as opposed to posing merely a danger to management positions),
and that the board’s response was proportional to the threat posed. The court
acknowledged that Mesa’s offer was coercive and would have forced shareholders to
tender their shares at the front-loaded tender offer, out of fear that they will be forced, by
Mesa, to later take the inferior junk bonds in the back-end merger. The court found that
excluding Mesa from the self-tender offer was thus reasonable because of the inadequacy
and coercive nature of Mesa’s tender offer.441
In response to the Supreme Court’s decision in Unocal, the Security Exchange
Commission (SEC) adopted rule 14d-10,442 which provides, inter alia, that no bidder shall
make a tender offer unless, “[t]he tender offer is open to all security holders of the class
of securities subject to the tender offer . . .”. Thus, the SEC effectively terminated the
viability of exclusionary self-tender offers as a stock repurchase technique.443 The rule,
sometimes termed “all holders” rule, apparently applies to tender offers extended by
issuers as well as any other third party bidders.
c.
The Status Of Greenmail After Unocal
With the SEC’s overruling of exclusionary self-tender offers as valid takeover
defenses, the legality of other repurchase practices, which discriminate among
shareholders of the same class, was cast into doubt. At present, while Unocal’s
440
See Bielawski, supra note 415, at 101, citing Unocal, 493 A.2d at 955.
Id.
442
17 C.F.R. § 240.14(d)-10 (2001).
443
Bielawski, supra note 415, at 96.
441
109
discriminatory share repurchase program would probably be contrary to federal securities
laws, it appears that the validity of greenmail as a discriminatory treatment of
shareholders (of the same class of stock) will be upheld.
In Grobow v. Perot. (1988),444 the Supreme Court of Delaware approved the
payment of a large premium to the corporation’s largest shareholder, thereby affirming
the validity of a corporation’s right to selectively repurchase its shares, and pay
greenmail, under Delaware law.445 In a later suit, brought under the federal securities and
Delaware state law, the court upheld the validity of a selective repurchase on facts similar
to Grobow.446 In that case, the court refused to classify a repurchase agreement as a
tender offer under the Williams Act because the agreement was privately negotiated
between parties familiar with the intrinsic value of the stock. As such, the defendant was
under no duty to extend the terms of the repurchase to any other shareholder.447
iv.
Selective Repurchases In Israel
a.
Greenmail
Repurchase transactions involving the payment of greenmail are yet another
practice that might call to the close attention of Israeli courts.
Israel, which only recently included in its corporation law the possibility for
corporations to repurchase their stock, has not had the opportunity to examine greenmail.
444
539 A.2d 180 (Del. 1988), aff'd, 526 A.2d 914 (Del. Ch. 1987).
Bielawski, supra note 415, at 97. However, see id. at 130-31 for an analysis of the unique
elements in Grobow, which are distinguishable from other greenmail related case law. And see id. n.214
(“All the cases cited by the [Grobow] court involve a different factual setting in which the payment of
greenmail is usually justified . . . [these cases are:] Cheff (citation omitted) (control premium and threat of
liquidation); Edelman v. Phillips Petroleum Co. (citation omitted) (control premium and hostile tender
threat); Lewis v. Daum (citation omitted) (threat to future corporate policy and control premium); Kaplan
(citation omitted) (threat to corporate control and control premium); Kors (citation omitted) (control
premium and threat to future business of the company).”).
446
In re General Motors Class E Securities Litigation, 694 F. Supp. 1119 (D. Del. 1988).
447
Bielawski, supra note 415, at 133.
445
110
It is not likely, however, that Israel will fully adopt Delaware’s liberal approach on the
matter,448 though both the Supreme Court of Israel and the legislator continually express
the wish to provide a more liberal framework for Israeli corporations to compete in.
At the center of Israeli legal debate, is the question of how much latitude should
corporate insiders receive in responding to a control contest.449 Management is faced with
a clear conflict of interest in considering how to react to control threats.450 They are
expected to take action designed to defeat a hostile acquisition of control, because of
personal fears that the new controlling party will replace them. Some predominant legal
writers claim that this is a sufficient reason to restrict management from taking active
steps to trample hostile offers.451 On the other hand, many provisions in the Companies
Law do provide management with leeway in responding to hostile bids, for the purpose
of defending shareholders interests.452 It appears likely that, at least initially, Israeli
courts will focus on the objectives behind a managerial decision to pay greenmail, and
strike down decisions that are clearly self motivated and unreasonably undermine
shareholders’ best interests. Thus far, it is widely suggested that, currently, in the context
of hostile takeovers, management may respond restrictively, only to protect shareholders
interest.453
b.
Exclusionary Repurchases
By removing the provisions that prohibited Israeli corporations from repurchasing
their own shares, exclusionary self-tender offers may have become a new instrument for
448
The statement is the author’s personal conviction.
GROSS, supra note 40, at 375.
450
BAHAT, supra note 47, at 859.
451
GROSS, supra note 40, at 375. And see The Companies Bill, explanatory notes § 375.
452
GROSS, supra note 40, at 368.
453
Id. at 375.
449
111
Israeli corporations, in defeating against hostile bids. Thus far, there is no case law or a
regulatory scheme to clarify whether exclusionary self-tender offers are a feasible form of
defense.
Nonetheless, Chapter II of the Companies Law provides that where, as a result of
the acquisition, the acquirer is expected to realize control over the firm454 or is expected
to raise his holdings beyond a 45% threshold,455 the acquisition must be preceded by a
“special” tender offer. The rules pertaining tender offers are outlined, in general, in the
Securities Regulations (Tender Offers), 2000,456 however, no particular reference is made
to exclusionary self-tender offers per se.
Because tender offers are recognized as a feasible cause of tension for corporate
management,457 management’s ability to influence the effectiveness of a pending tender
offer is limited, through legislation, primarily, to providing an opinion on the quality of
the offer and to conducting negotiations with the offeror and/or alternative buyers.458
Prior to the Companies Law and the Securities Regulations, tender offers were a
poorly regulated subject matter. The Companies Ordinance, a derivative of the English
Companies Act, was lacking a regulatory framework on tender offers. This in turn
promulgated much case law with respect to third party tender offers.459 At present, the
Companies Law, and the supplementary regulations of the Securities Act,460 provide a
more comprehensive structure for tender offers.
454
Twenty-five percent, where there is no controlling shareholder
Providing that no other shareholder holds more than 50% of the firm’s voting power.
456
Securities Regulations (Tender Offers), 2000 (hereinafter Securities Regulations, 2000).
457
A pending offer for the purchase of control may pose a threat to the continuation of the existing board.
458
The Companies Law, 1999, 330 S.H. 189.
459
For tender offers prior to the Companies Law see C.C. (T.A.) 201117/98, Meshulam Levinstein
& Saul Lotan v. Edgar Investments and Development (1998); GROSS, supra note 40, at 366-82; BAHAT,
supra note 47, at 828-66.
460
The Securities Regulations, 2000.
455
112
One of the items that the legislator addressed in the new securities regulations and
the Companies Law was the need to protect the rights of public shareholders in
acquisitions of large stakes, which are conducted beyond the scope of market
pressures.461 In order to level the playing field, and to make the shareholders effectively
alert to offers that might result in a change of control,462 the practice of creeping
acquisitions463 was eliminated.464 By making the shareholders aware of a possible control
struggle, shareholders were given the opportunity to demand appropriate control
premiums for their stock.465 In addition, members of management were made accountable
to the bidder and the offerees, for actions taken with the purpose of trampling current or
foreseeable special tender offers. In defense of their actions, management could
demonstrate that they have acted upon the good faith belief that such actions were
warranted in the best interest of the corporation.466
Section 5 of the Securities Regulations467 provides that tender offers must be
made equally to all the security holders of the class of securities that is subject to the
offer. Section 5 resembles in this respect rule 14d-10 of the SEC, in that it apparently sets
aside exclusionary self-tender offers.
Though it is not discussed in legal literature, it is possible, (no evidence pointing
to the contrary) that this rule applies equivalently to tender offers extended by issuers.
461
The Companies Law, 1999, explanatory notes.
The Companies Bill, explanatory notes, Chapter 5, part 9.
463
A series of continuous small acquisitions, that ultimately secures control for the acquirer.
464
The Companies Law, 1999, 328 S.H. 189.
465
BAHAT, supra note 47, at 854.
466
The Companies Law, 1999, 330 S.H. 189. See also BAHAT, supra note 47, at 859.
467
The Securities Regulations, 2000.
462
113
CHAPTER 7
LIABILITY FOR IMPROPER DISTRIBUTIONS
Under both Delaware and Israeli law, director liability on account of an improper
repurchase is similar to that imposed for an improper dividend. The board of directors
and/or the shareholders may be accountable for restitution to either the corporation or
directly to the creditors. Furthermore, both jurisdictions will most likely hold directors
personally liable under the more general duties of good faith and loyalty, for knowingly
approving an improper distribution.
The directors of a Delaware corporation are subject to joint and individual
liability,468 for willful or negligent, unlawful distributions.469 However, a director may be
exonerated from such liability, if he or she expressly dissented the distribution,470 and if
he or she relied,
[I]n good faith upon the records of the corporation and upon
such information, opinions, reports or statements presented to
the corporation by any of its officers or . . . by any other person
468
DEL. CODE ANN. tit. 8 § 172 statutory notes (2001) (“This section contemplates the recovery
and restoration to the capital of the corporation, of the entire amount thus illegally withdrawn; and to that
end each director is made individually liable for such amount. John A. Roebling’s Sons Co. ex rel. Whitley
v. Mode (citation omitted).”).
469
DEL. CODE ANN. tit. 8 § 174 (2001). See generally Roberts & Pivnick, supra note 147, at 67.
And see id. § 174 statutory notes (for the scope of this section):
This section imposes liability for unlawful distributions and dividend
payments in addition to restricting purchase of a corporation’s own shares of
capital stock; company’s financing of leverage buyout transactions may
properly be treated as an unlawful dividend payment or distribution from
company to its parent company and sole shareholder. Official Comm. of
Unsecured Creditors of Buckhead Am. Corp. v. Reliance Capital Group, Inc.
(citation omitted).
470
DEL. CODE ANN. tit. 8 § 174(a) (2001).
113
114
as to matters the director reasonably believes are within such
other person’s professional or expert competence and who has
been selected with reasonable care by or on behalf of the
corporation, as to the value and amount of the assets, liabilities
and/or net profits of the corporation or any other facts pertinent
to the existence of surplus or other funds from which dividends
might properly be declared and paid, or with which the
corporation’s stock might properly be purchased or redeemed.471
Once it is established that an unlawful distribution occurred, every shareholder is
compelled to return to the corporation that which he received, unless the shareholder did
not know, and should not have known (objectively), that the distribution was unlawful.472
In examining foul play, the shareholders of Israeli public corporations enjoy a
presumption of “ignorance”, provided that they were not in the position of a controlling
shareholder, director, or chief executive, at the time of distribution.473
An unlawful distribution, plainly implicates the directors of an Israeli
corporation.474 Directors, who fail to demonstrate one of the following alternatives, will
be regarded as having breached their duty of loyalty.475 The directors must show that they
either opposed the decision to make the distribution and had taken all reasonable
measures to prevent it,476 or that they did not know, and under the circumstances could
not have known, that the distribution was improper.477 The directors may claim that they
471
Id. § 172. See also Klang, v. Smith’s Food & Drug Centers, 1997 Del. Ch. LEXIS 73, *16, Del.
Ch., C.A. No. 15012, Chandler, V.C. (May 13, 1997), and Aronson v. Lewis, Del. Supr., 473 A.2d 805,
812 (1984), Smith v. Van Gorkom, Del. Supr., 488 A.2d 858 (1985) (for the proposition that only if the
decision making process is grossly negligent may liability for damages, resulting from a good faith
decision, be found).
472
The Companies Law, 1999, 310 S.H. 189.
473
Id. § 310(b).
474
Id. §§ 254-57.
475
Id. §311. See also 1 URIEL PROCACCIA, HOK HAVAROT HADASH BE’ISRAEL [New Corporations
Law in Israel], 517-22 (1994).
476
The Companies Law, 1999, 311 S.H. 189. The scope of this principle is unclear. Existing case
law is helpful in evaluating the gravity of this principle as an alternative. See C.C. (Jm.) 400/89, Official
Receiver for North America Bank Ltd., Liquidator v. Zusman & Others, P.M. 3(2) (1984); GROSS, supra
note 40, at 357.
477
Id. § 311(b).
115
reasonably relied, in good faith, on inaccurate information when lending their approval,
however, they will need to demonstrate that had the information they relied upon been
correct, the distribution would have been proper.478
Under Delaware law, directors that approve an unlawful distribution are entitled
to be subrogated to the rights of the corporation, against stockholders who accept the
proceeds of a distribution with knowledge of facts that indicate illegality.479
An exception, unique to Israeli law,480 authorizes creditors to submit a derivative
claim against the corporation for an unlawful distribution.481 Being derivative, however,
it is the corporation, and not the creditors, that will enjoy its fruits, despite the fact that it
was the creditors who brought the action. The burden of proof remains, nonetheless, on
the shoulders of the creditors to show that the distribution had rendered the corporation
unable to pay its debts.482
An important implication in associating unlawful distributions with a breach of
duty of loyalty (as opposed to duty of care), is that directors cannot purchase insurance
against breach of loyalty.483 In terms of indemnification, section 261 of the Companies
Law restricts indemnification to instances where the director proceeded in good faith
belief that he or she was acting in the best interest of the corporation.484
478
The Companies Law, 1999, 311(c) S.H. 189.
DEL. CODE ANN. tit. 8 § 174(b), (c) (2001). On stockholders liability for unlawful distributions
see generally, Norwood P. Beveridge, Jr., Does a Corporation’s Board of Directors Owe a Fiduciary Duty
to Its Creditors?, 25 ST. MARY’S L.J. 589, 610 (1994).
480
See Cohen, Directors’ Negligence Liability to Creditors, supra note 339. In contrast, Delaware
creditors have a right of action against the corporation only in the context of insolvency. DEL. CODE ANN.
tit. 8 § 174 (2001).
481
The Companies Law 1999, 204, S.H. 189.
482
GROSS, supra note 40, at 356.
483
The Companies Law, 1999, 258(a) S.H. 189. Insurance is available, however, for breaches of
duty of care. See id. § 258(b).
484
Id. § 261(2).
479
116
Following substantial criticism by the legal community, the Justice Department
of Israel rewrote section 311 of the Companies Law. In a recent amendment, pending
parliament’s approval, it was suggested that the burden placed on directors with respect
to improper distributions be moderated. It is recommended that the provision, which
relates a breach of duty of loyalty to unlawful distributions, be replaced with a
provision that associates unlawful distributions to a general breach of duty. The first
implication of this amendment, if approved, will be to empower the courts to determine
whether the distribution represents a breach of duty of loyalty or a breach of duty of
care. The second implication is that Israeli corporations could purchase insurance for
unlawful distributions resulting from breach of duty of care.
It is further recommended that Israeli corporation law continue to make it
impossible for corporations to excuse directors, in advance, for distributions resulting
from a breach of duty of care. The rationale being that renouncing the right to collect
capital that is duly payable to the corporation (as a result of an unlawful distribution),
will unduly injure the creditors of the corporation.485
In comparison, Delaware generally authorizes corporations to write into the
articles of incorporation a provision that reduces or eliminates the financial
responsibility of the creditors. However, such indemnification or exculpation provision
does not have the power to excuse unlawful behavior and breaches of loyalty,486
including acts or omissions not in good faith, or which involve a knowing violation of
485
The Companies Law Memorandum (2001), The State of Israel Ministry of Justice, available at
http://www.justice.gov.il/legal/tazkir/tazkir.htm
486
DEL. CODE ANN. tit. 8 § 102(b)(7) (2001).
117
law, unlawful dividends or stock repurchases, and transactions in which the directors
derive a personal benefit.487
487
Sandra Miller, Piercing the Corporate Veil Among Affiliated Companies in the European
Community and in the U.S.: A Comparative Analysis of U.S., German, and U.K. Veil Piercing Approaches,
36 AM. BUS. L.J. 73 (1998).
118
CHAPTER 8
CONCLUSION
This thesis demonstrates how the distribution of dividends and the acquisition by
a corporation of its own stock may translate into a direct transfer of value from creditors
to shareholders.
Because equity owners are generally not accountable for liabilities exceeding their
investment, without the constraints of the law they could escape the burden of debt by
paying out the corporation’s assets in the form of dividends, or through the reacquisition
of stock.488 It is suggested that creditors have a legitimate concern that the shareholders
of leveraged corporations, and managers as well, in certain circumstances, might cause
the corporation to undertake riskier investments than would be optimal for a nonleveraged corporation, especially when the corporation is approaching insolvency. In the
absence of a special agreement with the corporation, the disposition of individual
creditors is adversely affected by distributions of assets and increases in the aggregate of
outstanding claims against the corporation.
Though the equity cushion is a recurring theme in the legal capital model, it is
widely suggested that it provides no significant protection to creditors. In fact, statutory
provisions that allow reduction surpluses and revaluation surpluses, effectively castrate
the restrictions placed on distributions. Furthermore, the legal capital rules never
prevented the erosion of corporate assets nor did they prevent the incurrence of
488
See discussion infra part 2.I-II.
118
119
additional, possibly secured or senior, corporate debt. The ease with which stated capital
could be reclassified as surplus, suggests that legal capital presents no real obstacle to
distributions.
Critics maintain that creditors have better means to protect their interests.489 It is
suggested that debtholders anticipate and estimate risk-increasing behavior prior to
advancing loans to the corporation. Assuming this presumption is well-founded, creditors
are in a position to demand, among other things, an interest rate commensurate to the risk
that they anticipate, and write restrictive covenants into the debt agreement to inhibit the
corporation from assuming risky projects. If the creditors indeed have better means to
protect their interests, then perhaps the added strain that the legal capital model imposes
on corporations is overprotective of creditors and unreasonably interferes with the
corporation’s autonomy.
Dividends and share repurchases may be central considerations for prospective
investors.490 They may become an important component in the appreciation of risk,
particularly with respect to high-risk investments, where the corporation’s ability to
increase its earnings is uncertain. In distributing wealth to the shareholders, those risks
may be gradually downgraded. Furthermore, if investors actually regard distributions as a
signaling function of the firm’s potential, the ability of corporate insiders to transmit
messages via the stock market may prove crucial in certain circumstances.
Distributions may play a central role in the corporation’s financial strategy. They
may have the effect of raising earnings per share, rewarding non-selling shareholders of
undervalued stock, reducing aggregate dividends and other shareholder servicing costs,
489
490
See discussion infra part 4.
See discussion infra part 5.
120
satisfying stock options (without diluting earnings per share), or eliminating fractional
shares. Other business purposes may include manipulating stock value, tax incentives, or
even as a device for reducing the issuer’s vulnerability to unsolicited acquisitions and
defeating unwanted takeover bids.
Nevertheless, despite the multiple benefits that repurchase plans and dividends
present, critics often discard them for being used to purposely manipulate stock prices.
The market crisis that Israel experienced in 1983 is a classic illustration of the weight of
such concerns.
The corporation codes of Israel and Delaware shared little resemblance before
1999, despite the fact that both legal systems were originally the product of nineteenth
century English law. The introduction of the new Companies Law symbols a shift
towards the liberalization of commercial law in Israel. The deletion of some hard-line
restrictions on share repurchases and the adoption of a nimble dividends provision, were
both vital changes, especially suitable for the survival of some corporations in the down
sloping economy. However, many provisions in the Companies Law pertaining
distributions, remained particularly inflexible as compared with parallel laws
elsewhere.491
Despite efforts to modernize the Israeli corporation code and to make it
competitive with other popular foreign jurisdictions, Delaware remains a more promising
destination. The Delaware code continues to surpass Israel in its flexibility and broad
approach to distributions. For one thing, while both jurisdictions stipulate that
distributions be made out of profits and surpluses, Delaware’s G.C.L. deems the entire
491
See discussion infra parts 3.III, 6.II.
121
surplus, earned or unearned, including paid-in surpluses, as viable sources for that
purpose. In contrast, under Israeli law, distributions may only be made out of the retained
earnings account, forbidding distributions from any and all stock capital regardless of its
designation.
Above and beyond the retained earnings test, the new Companies Law poses an
additional test of insolvency.492 The insolvency test essentially bans distributions that
raise reasonable concerns that they might hinder the corporation’s ability to meet existing
and anticipated liabilities. However, what is a reasonable concern and what does “being
able to meet” mean? What exactly are “anticipated liabilities”? The new Companies Law
resorts extensively to concepts which boundaries have yet to be determined. This leaves
much leeway for court intervention, and very little certainty for the parties affected by it.
Until the courts construe these notions, there is no estimating their precise legal import.
Regarding director’s liability for improper distributions,493 it is generally
accepted, both under Israeli and Delaware law, that the directors of a solvent corporation
do not owe the creditors any duty other than duties arising with respect to compliance
with the terms of the debt. However, the import of the insolvency test into the Israeli
formula for distributions, may have introduced far-reaching consequences to which
Israeli directors are not yet aware of. While it remains uncertain whether and to what
extent directors owe a duty to creditors while the corporation is solvent, it is clear that a
special duty exists once the corporation enters insolvency.
It is likely that Israeli courts will consider the line that Delaware courts have taken
on this topic. Before Credit Lyonnais, Delaware case law clearly proposed that while the
492
493
See discussion infra parts 6.II.iii.
See discussion infra part 7.
122
corporation was solvent, directors were released of all but their contractual duties to
bondholders. Once insolvency in fact occurred, then per Geyer, directors owed fiduciary
duties to the creditors. In Credit Lyonnais, however, the Delaware Court of Chancery
suggested that fiduciary duties materialize, at the vicinity of insolvency, to a community
of interest that is larger than that earlier identified. Credit Lyonnais has left a trail of
uncertain issues including, what is the trigger mechanism at which a corporation enters
the vicinity of insolvency. What is the breadth of the community of interests that
directors need to consider, and what is the scope of the duty to them?
In the context of defensive actions aggravated by a takeover threat,494 Delaware
courts have long recognized that a potential conflict of interest between directors and
other constituencies, necessitates that the business judgment rule will not automatically
apply to the conduct of Delaware directors. Israeli courts have not yet had the opportunity
to consider the application of the business judgment rule in this specific context and, thus,
continue to apply the presumptions of the business judgment rule as to any other business
decision. It is likely that when Israeli courts tackle defensive share repurchases as a
distinctive phenomenon, they will consider customizing U.S. methodology on the subject.
Nevertheless, the legitimacy of poison pill redemption plans in Israel is doubtful even
after the Companies Law. The validity of greenmail is yet to be examined, having that
share repurchase is a novelty in itself. Thus, until Israeli courts address this question, it
may be that redemptions plans and transactions involving greenmail that are intended to
thwart hostile bids, will be carefully scrutinized under the general requirements for
distributions. Delaware courts are expected to uphold redemption plans, whose purpose is
494
See discussion infra parts 6.III.ii-iv.
123
to avoid a hostile takeover that could be potentially damaging to the corporation, as well
as transactions involving the payment of greenmail under the same circumstances. The
validity of exclusionary self-tender offers, however, appears to have been ousted in both
Delaware and in Israel.
Finally, both jurisdictions hold directors personally liable, under the more general
duties of good faith and loyalty, for knowingly approving an improper distribution.495
The directors of both Delaware and Israeli corporations will be liable for a willful or
negligent unlawful distributions. They may be exonerated from such liability, if he or she
expressly dissented the distribution, or relied on inaccurate information in good faith.
However, currently, Israeli directors may be liable for breach of duty of loyalty in
instances where their approval was negligent. Unless Israeli legislators amend the
Companies Law to associate improper distributions with a general duty to the
corporation, as opposed to a strict duty of loyalty, Israeli directors will continue to bear
an exceptionally heavy burden.
Seeing as the availability of distributions is a main consideration weighing with
investors as they decide where to put their money and where to set up their business,
over-restrictive provisions may operate to the detriment jurisdictions that seek to become
competitive, like Israel. The new Companies Law inclines partly toward full market
freedom, and partly toward paternalism. It apparently disregards the latter-day fact that
market forces may have the ability to balance asymmetries in power between the
bondholders and the corporation, making legislative intervention in itself a disruptive
element.
495
See discussion infra part 7.
124
Israel’s new Companies Law, even if it has the pretensions of being the most
equitable, is also very innovative and unique. As such, it is also less clear, less simple,
less user-friendly, and the business arrangements it calls for are loaded with uncertainties.
In a global competitive market that is ultimately dominated by systems of easiest,
clearest, simplest, and most worthwhile laws496 governing economics, securities, tax and
companies, Israel might continue to lose out in favor of other jurisdictions, particularly
Delaware.
496
Not the most moral and the most equitable.
125
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